Preparation for Addressing Universal Service Issues: A Review of Current Interstate Support Mechanisms Common Carrier Bureau Federal Communications Commission Washington, D.C. 20554 February 23, 1996 Preparation for Addressing Universal Service Issues: A Review of Current Interstate Support Mechanisms Universal Service Task Force Deborah A. Dupont, Task Force Leader Common Carrier Bureau, Accounting & Audits Division Ted Allen (Intern) -- Common Carrier Bureau, Policy Division Margo Domon -- Cable Services Bureau, Policy Division Daniel F. Grosh -- Wireless Telecommunications Bureau, Policy Division Robert Hall -- Common Carrier Bureau, Accounting & Audits Division George Johnson -- Common Carrier Bureau, Accounting & Audits Division Clara E. Kuehn -- Common Carrier Bureau, Accounting & Audits Division Rafi Mohammed -- Common Carrier Bureau, Accounting & Audits Division Andrew G. Mulitz -- Common Carrier Bureau, Accounting & Audits Division Mark S. Nadel -- Common Carrier Bureau, Policy Division Jonathan Reel -- Common Carrier Bureau, Accounting & Audits Division Douglas L. Slotten -- Common Carrier Bureau, Policy Division February 23, 1996 Table of Contents PRELIMINARY STATEMENTS AND SUMMARY Purpose of the Report 1-2 Organization and Summary of the Report 2-10 PRELIMINARY CONSIDERATIONS A Review of Telephone Subscribership Studies: Why Some Households Are Not Connected to the Network 11-24 Observations Regarding the Implications of Competition for Universal Service Issues 25-33 EXPLICIT SUPPORT MECHANISMS For Individual Telephone Subscribers: Lifeline and Link Up 34-44 Telecommunications Relay Service (TRS) for Hearing-Impaired Telecommunications Users 45-49 For Local Exchange Carriers: The Universal Service Fund 50-65 Dial Equipment Minutes (DEM) Weighting 66-70 Long Term Support (LTS) 71-77 Rural Utilities Service Loan Subsidies for Telephone Service78-89 IMPLICIT SUPPORT AND OTHER PRICING PRACTICES Recovering the "Interstate" Portion of the Cost of Subscriber Lines: Carrier Common Line Charges (CCLCs) and Subscriber Line Charges (SLCs)90-99 Study Area Access Rate-Averaging 100-106 Non-Traffic-Sensitive Switching Costs 107-110 Interim Transport Rate Structure 111-124 Other Areas to Investigate 125-128 PRELIMINARY STATEMENTS AND SUMMARY Purpose of the Report During the past several years, the Federal Communications Commission ("Commission") has devoted significant resources to addressing the issue of support mechanisms, both explicit and implicit, in the regulated telecommunications industry. The subject of subsidies has arisen in numerous Commission proceedings, as a focal point in some proceedings and as a subsidiary issue in other proceedings. Examining the functions and effects of subsidies in the telecommunications industry is an attempt to serve two policy objectives: to ensure that the telecommunications needs of consumers and society are met, and to remove barriers to competition in various telecommunications submarkets. Both of those policy objectives are prominent underlying principles of the recently-enacted telecommunications legislation. The Telecommunications Act of 1996 emphasizes the importance of support mechanisms to ensure that telecommunications users are provided with quality services at affordable rates. In addition, the Act stresses the need to promote increased availability of advanced telecommunications services, especially for schools, health care providers, and libraries. The legislation also contains numerous provisions designed to ensure an opportunity for fair and full competition in the telecommunications industry. Numerous sections of the new Act convey Congress' intent that the Commission thoroughly review the existing system of federal mechanisms supporting universal service. Moreover, in the accompanying conference report, the conferees declare that "any support mechanisms continued or created under [the relevant portions of the new Act] should be explicit, rather than implicit as many support mechanisms are today." The primary purpose of this report is to facilitate the review of support mechanisms that the conferees intended be undertaken by providing regulators and interested parties with background information regarding many of the current interstate support mechanisms, both explicit and implicit. In this report, we summarize existing support mechanisms only, and we do not address implementation of new universal service support responsibilities arising under the new Act. For that reason, we do not discuss future support mechanisms for public schools and libraries or public and nonprofit healthcare providers in rural areas. In addition to subsidies and pricing practices that are generally recognized as universal service support mechanisms, we also discuss pricing practices that have drawn criticism for creating alleged cross-subsidies between users or customers. Such practices may or may not constitute support mechanisms for universal service, but we include a description of them because they are closely related to many of the pricing practices that constitute implicit support for universal service. The description of each support mechanism includes an explanation of how it operates, a brief history of how it developed, an account of criticisms of the mechanism, proposals for reform suggested by interested parties, and a summary of the positions of many major interest groups. Our statements regarding the pricing practices and subsidies are not meant to constitute findings or conclusions, but rather to communicate preliminary information derived both from our own proceedings and from the media and other public forums. Similarly, descriptions of the positions of various interest groups and of criticisms of the support mechanisms are intended only to provide an informal summary of information derived from regulatory proceedings and public remarks of interested parties. Organization and Summary of the Report Preliminary to the description of the support mechanisms, the report begins with a brief discussion of what will be two essential factors in subsequent study of universal service: an exploration of the factors underlying a decision to subscribe--or not to subscribe--to telephone service and a review of potential competitive developments in the telecommunications industry. Telephone Subscribership. Over the last half-century, subsidies and transfer payments have played an important role in promoting the goal of universal service. Overall telephone subscribership in the United States steadily increased until the 1980s. Since then, however, subscribership has reached a plateau, currently at approximately ninety-four percent. The Commission requested comment on specific proposals for enhancing subscribership in a Notice of Proposed Rulemaking released on July 20, 1995. This report discusses several studies that have attempted to identify factors that deter telephone subscribership. Nonsubscribership is particularly high among the young, the unemployed, minority households with children, and those receiving public assistance. Low income households and households in nonpermanent living situations comprise the vast majority of nonsubscribers. Despite high overall subscribership rates, and recent gains among minorities, subscribership rates among African-American and Hispanic households have been consistently below those of White households by about ten percentage points. Most nonsubscribers are former subscribers who have been disconnected because they were unable to pay for toll charges. Studies also suggest that some households choose not to have a telephone to avoid unwanted intrusion. Given the positive correlation between income and subscribership and the fact that most of the households without telephones subscribed once, but now have been disconnected from the network, increasing telephone subscribership appears to depend upon the success of efforts to reduce disconnection and ease reconnection. Techniques employed in the states to achieve these ends are (1) prohibiting disconnection of local service for nonpayment of toll charges; (2) low cost toll call blocking services; and (3) streamlining procedures for eligibility and receipt of assistance. Implications of Competition. Competition in the local telecommunications markets has enormous potential to foster the goals of universal service. Competition creates incentives for companies to enter local markets with cost effective and technologically advanced systems. This results in consumers paying less for local service, at the same time spurring demand for new state-of-the-art telecommunications systems. In this manner, both subscribership and the scope of services increase. Existing assistance programs and pricing practices also promote universal service. On the other hand, competitive entry into local service markets may make it impossible for certain types of support to continue without disadvantaging one or more competitors in a given market. For example, local service pricing practices that implicitly subsidize other types of service or other categories of carriers may fail to reflect the underlying costs of service, distorting incentives for market entry. A competitively fair environment in the local telephone service market would serve universal service by allowing consumers to reap the benefits of competition. Support Mechanisms: Explicit and Implicit. The body of this report addresses two categories of support mechanisms: explicit and implicit. Explicit support mechanisms are assistance programs that provide subsidies targeted to specific groups of subscribers or types of local exchange carriers ("LECs"). Explicit mechanisms include the Lifeline Assistance and Link Up America programs, and Telecommunications Relay Services, all of which provide assistance to individual telephone subscribers. Other explicit mechanisms, including the Universal Service Fund, the dial equipment minutes weighting subsidy, the Long Term Support program, and Rural Utilities Service loan programs, provide support to LECs. The implicit support mechanisms are pricing practices that appear to create subsidies due to mismatches between costs and cost-recovery. In many cases, the implicit support mechanisms were not created pursuant to specific regulatory directives, but rather were the result of pricing and cost-allocation practices that arose in the prior monopoly service environment, and may not be sustainable in a competitive market. Interstate pricing practices providing such implicit support arguably include use of the carrier common line charge to recover a portion of the non-traffic-sensitive costs of the common line, some subscriber line charges, study area rate averaging, the recovery of non-traffic-sensitive switching costs on a traffic-sensitive basis, and the interim transport rate structure. Lifeline Assistance and Link Up America. Lifeline Assistance and Link Up America promote universal service by reducing the monthly rate or initial connection charge for elderly or low income telephone subscribers. The programs are managed by the states, which typically extend benefits to recipients of other social welfare services, such as Food Stamps or Medicaid. One study estimates that eighty percent of Lifeline recipients depend on the subsidy to make telephone service affordable. The National Exchange Carrier Association, Inc. ("NECA") administers funds for these programs through a Lifeline/Link Up pool, to which all interexchange carriers ("IXCs") having at least .05 percent of presubscribed lines nationwide contribute (on a flat-rate, per line basis). The Commission adopted the first of two Lifeline plans in 1984. This plan reduces an eligible subscriber's monthly telephone bill by an amount equal to the subscriber line charge ("SLC") (currently $3.50), with half the reduction coming from a fifty percent waiver of the SLC, and the rest from the participating state. The second Lifeline plan, adopted in 1985, waives the entire SLC, and is matched by the state, so a subscriber's bill is reduced by twice the SLC. Thirty-five states report subscribers receiving assistance under the second plan (only California still uses the first). About 4.4 million households received $123 million in Lifeline assistance in 1994. The Link Up America program helps low income subscribers begin telephone service by paying half of the first $60 of connection charges. Where a LEC has a deferred payment plan, Link Up will also pay the interest on the balance. To be eligible for Link Up, a subscriber must meet a state-established means test, and may not, unless over sixty years old, be a dependent. Link Up is available in all but three states. In 1994, about 840,000 households received $19 million in Link Up assistance. Telecommunications Relay Services. Telecommunications Relay Services enable persons with hearing or speech impairments to have full access to the voice telecommunications network. TRS facilities have specialized staff and equipment who relay conversations between persons using text telephones and persons using conventional telephones. To access TRS, a caller connects the text telephone through an acoustic coupling device to the telephone line (or directly to the telephone line with some text telephones) and dials a preassigned 800 number to reach the local TRS center. The caller communicates with one of the center's communications assistants by typing into the text telephone; the communications assistant places a voice call to the called party. Communications assistants serve as links in the conversation in a similar manner when a person without a hearing or speech impairment initiates the call. TRS services are required by the Americans with Disabilities Act of 1990 ("ADA"). The ADA requires that "users of telecommunications relay services pay rates no greater than the rates paid for functionally equivalent voice communication services." To implement the law, the Commission established a TRS Fund administered by NECA. All interstate telecommunications companies, data as well as voice (including LECs, IXCs, resellers, 900 services providers, and satellite, video, and paging providers), contribute to the TRS Fund in proportion to their gross interstate revenues. Currently, approximately 2,850 carriers contribute .03 percent of their gross interstate revenues to fund TRS at approximately $30 million each year. Universal Service Fund. The creation of a Universal Service Fund ("USF"), through which IXCs fund LECs' non-traffic sensitive local plant costs that exceed the national average, has its origins in the pre-divestiture interstate division of revenues and settlements process. In the pre-divestiture era, a significant number of high-cost LECs relied upon higher-than-average cost allocations to interstate services as a means of holding down local rate levels. Under current Commission rules, carrier costs (reported under the Part 32 Uniform System of Accounts) are allocated between regulated and nonregulated activities (pursuant to Part 64). Regulated costs are then separated into their interstate and intrastate components under Part 36 "jurisdictional separation" rules. Part 69 rules, in turn, specify the amounts LECs can charge IXCs for access (connection) to the local exchange. In particular, the rules allow LECs to allocate to IXCs twenty-five percent of their "loop" costs (fixed costs of connecting customers to the LEC central office). The USF operates through the Commission's jurisdictional separations rules to assist LECs with local loop costs above 115 percent of the national average. Without such assistance, costs currently allocated to IXCs via the USF would have to be recovered through increased charges for intrastate (including local) telephone service. In many high-cost areas, the resulting local rate increases could be substantial, potentially causing some telephone subscribers to discontinue service. NECA administers the USF. Each year NECA: determines the LECs' loop costs and number of working loops; calculates the total amount of USF assistance needed; and prepares tariffs to recover that amount from the contributing IXCs. Each IXC with at least .05 percent of presubscribed lines nationwide contributes to the fund an amount based on the number of its presubscribed lines. In 1994, the USF was $725.4 million and in 1995, $749.5 million. USF payments in 1996 will be $734.6 million. In August 1994, the Commission released a Notice of Inquiry asking commenters to address the appropriate level and targeting of high-cost assistance, the relationship between high-cost assistance and competition, and alternatives to the present high-cost mechanisms (one based on actual LEC costs, and one based on an incentive approach using proxies for actual costs). Responding commenters stated that as currently structured, the USF rules provide little or no incentive for many high-cost carriers to invest efficiently: LECs with less than 200,000 lines in a given state may allocate 90 percent to 100 percent of their incremental loop costs to the interstate jurisdiction. Commenters also argued that the present USF mechanism hinders competitive entry, because it provides assistance only to the incumbent LEC, which allows it to price services at below cost levels that potential competitors, without access to USF assistance, cannot meet. On July 13, 1995, the Commission issued a Notice of Proposed Rulemaking and Notice of Inquiry inviting comment on three proposals for revising USF assistance. In the first proposal, three alternative modifications to the existing rules were presented, each of which would continue to base high-cost assistance on actual costs. The second proposal would allocate high-cost assistance on the basis of proxy factors, rather than actual costs. In the third proposal, proxy factors would be used to allocate assistance among the States; then, State utility commissions would decide the distribution of assistance among the carriers serving a State, under plans developed pursuant to general Commission guidelines and reviewed by the Commission. In addition, as an adjunct to any of the three proposals, comment was requested on the use of high-cost credits allowing customers to direct USF assistance to chosen carriers. Dial Equipment Minutes Weighting. Based on the assumption that smaller telephone companies have higher local switching costs per line because they cannot take advantage of certain economies of scale, current rules relieve such companies of the need to recover some of these costs through intrastate service rates by allocating additional costs attributable to such equipment to interstate traffic. The Commission's jurisdictional separations rules allocate local switching equipment costs between the interstate and intrastate jurisdictions on the basis of each jurisdiction's relative number of dial equipment minutes of use ("DEM"). Dial equipment minutes are the minutes of holding time of originating and terminating local dial switching equipment. For small LECs (with fewer than 50,000 access lines) the DEM is weighted (multiplied) to allocate additional costs to the interstate jurisdiction. DEM weighting is specifically provided outside of, and unrelated to, the Universal Service Fund assistance program. It applies to small carriers only, because in theory smaller companies have higher switching costs per line because they lack economies of scale. The weighted DEM subsidy is funded by those who pay switched access charges: the IXCs, and ultimately their customers. NECA estimated the total subsidy resulting from DEM weighting for 1995 to be about $311 million. DEM weighting may contribute to an overall competitive advantage for any IXC that does not carry the same cost burden. Additionally, DEM weighting causes customers to pay higher interstate long distance rates than are justified by cost. Finally, the aggregate costs removed from the intrastate jurisdiction via the various subsidy mechanisms (including DEM weighting) may allow certain LECs to charge below cost prices for local exchange services, which may deter the entry of potential new local market competitors. Critics of DEM weighting charge that assistance to small carriers is less necessary than it once was, because switching technology has significantly reduced cost-per-line differences, making DEM weighting, in reality, a subsidy to small companies, not necessarily high-cost companies. In the July 1995 Universal Service Fund Notice of Proposed Rulemaking and Notice of Inquiry, the Commission invited comment on proposals to abolish or revise the current DEM weighting assistance mechanism. One proposal for revision would combine both loop and switching cost factors into a single form of high-cost support. The other suggested revision would preserve the current DEM weighting mechanism, but with assistance provided to high- cost LECs or LECs using small switches rather than to small LECs. Long Term Support. The Long Term Support program reduces the pressures on IXCs to deaverage their interstate toll rates by supporting local telephone companies with higher-than-average subscriber line costs. LTS payments provide those high-cost LECs who are members of a NECA pool with enough support to enable them to charge IXCs a nationwide average carrier common line interstate access rate, but still recover the full interstate portion of their subscriber line costs. LTS payments, the difference between the pool members' actual costs and the rates charged to IXCs, are funded by larger LECs outside the pool. In turn, lower cost LECs charge IXCs rates above their interstate costs and contribute the difference to the pool. IXCs then pass this cost on--in the form of higher rates--to consumers calling from or to low cost areas, when they set geographically averaged rates. LTS is a subsidy because it is provided to LECs in high-cost areas by low cost LECs outside those areas. Support generally flows from urban and other high density locations to rural and other low density locations. The LTS subsidy has been subject to several criticisms: the LTS may inefficiently suppress demand; and it may encourage inefficient entry in markets served by LECs forced to collect and pass on the cost of LTS, while discouraging efficient entry in markets served by LEC recipients of LTS. Rural Telephone Loans. Since 1949, the Rural Utilities Service ("RUS"), formerly the Rural Electrification Administration, has provided loan assistance to rural telephone companies to finance the acquisition, construction and installation of telephone facilities to furnish and improve telephone service in rural areas. The RUS uses three mechanisms: (1) insured, direct five percent or "cost-of-money" loans; (2) direct loans from the Rural Telephone Bank ("RTB") made at the cost of money to the RTB; and (3) RUS guarantees of market rate loans made by the RTB and other banks. Loans under these programs subsidize telephone companies and cooperatives insofar as the Federal Government provides loans to the borrower at rates below the cost to the Government of obtaining those funds. Rural telephone loan subsidies have successfully targeted rural households and undercapitalized rural telephone companies. Currently ninety- six percent of rural households have telephones. Rural telephone borrowers, in turn, have become increasingly financially stable. These very successes suggest to some critics that the continuation of the subsidies is undesirable. Carrier Common Line and Subscriber Line Charges. The carrier common line charge ("CCLC") and the subscriber line charge ("SLC") (which is also known as an end user common line charge) are collected by local telephone companies to cover the interstate portion of the cost of subscriber lines. The SLC is a flat rate monthly charge assessed to end user customers, up to $3.50 per line per month for residential and single line business customers and up to $6 per line per month for multi-line business customers. The CCLC is a per minute charge assessed to IXCs to collect the remaining interstate common line costs. CCLC payments represent subsidies to the degree that customers' lines with the most traffic recover more than the interstate portion of their subscriber line costs, while customers' lines with the least traffic recover less than the interstate allocation of the cost of those lines. Since the cost of providing the subscriber line to customers is not sensitive to the amount of traffic it carries, the Commission initially proposed to recover it through a flat monthly fee, but opponents of a SLC argued that such a charge would price telephone service beyond the budgets of a significant portion of telephone subscribers, and thus diminish overall levels of telephone subscribership. While the CCLC may have fostered universal service by keeping subscribers' total fixed monthly charges lower than they would otherwise have been, detractors have pointed to a number of drawbacks. One primary concern of commentators has been a potentially diminished demand for toll service caused by the higher per minute prices for access caused by CCL charges, which is alleged to yield inefficiency losses on the order of a billion dollars per year. CCLC subsidies are also criticized as detrimental to the development of fully competitive telecommunications markets because unnecessarily high CCLC rates may cause incumbent LECs to lose their public network customers with the highest levels of interstate traffic to alternative providers not burdened with these costs. Some argue that CCLC subsidies distort competition for those customers with the lowest volume of interstate traffic. They contend that, because these customers generate such low levels of interstate traffic, LECs who serve them do not recover enough in CCL charges to cover their actual interstate costs. Ironically, SLC and CCLC subsidies may also force low income individuals who make many interstate calls to subsidize wealthy individuals who do relatively little interstate calling. AT&T and GTE, among others, have advocated that the entire amount of non-traffic sensitive ("NTS") common line costs should be recovered on a per month rather than per minute basis, via a SLC. Study Area Access Rate-Averaging. Under the current access charge rules, LECs are generally required to offer interstate access services at averaged rates throughout each study area, which usually encompasses all of a LEC's local exchange operations within a state. Interstate access rates, therefore, usually do not reflect: (1) the differences between the unit cost of providing service in high density and low density service areas; (2) the differences in the cost of the technology used to provide the underlying facilities for a particular service; or (3) for some services, such as common line, the length of the transmission path as a factor in the pricing of the service. Rate averaging, however, enables a LEC to avoid the potentially higher administrative costs of implementing de-averaged rates. The Commission has permitted two forms of pricing that mitigate the effects of this rate averaging to different degrees. First, LECs are permitted, subject to certain limitations, to price their interstate special access and switched transport services at different levels in different zones within a study area. Second, within a particular study area, LECs may offer volume and term discounts that are cost-supported under the Commission's new services test for price cap regulation if there is sufficient evidence that a given level of competition exists within the study area. Rate averaging has also been criticized as encouraging uneconomic market entry in areas in which rates are higher than underlying costs, even if the entrant may not be the most efficient provider. Conversely, rate averaging is said to deter competitive entry in high-cost areas because the LEC's prices in those areas are below the LEC's real costs of providing service. Some parties allege that rate averaging may erode the LEC's customer base to absorb the costs of supporting the high-cost portions of the switched access network. Non-Traffic Sensitive Switching Costs. The access charge rules recover local switching costs allocated to the interstate jurisdiction by the separations process through a per minute charge assessed upon IXCs even though, as some parties allege, a significant share of the local switching costs are NTS in character. One example of an NTS switching cost is the line card necessary to drive an integrated services digital network ("ISDN") channel over a twisted wire pair. An ISDN line card, an interface circuit in the central office local switch, is necessary for each ISDN loop. Recovering NTS switching costs on a traffic sensitive, or usage sensitive, basis has been criticized as creating economic distortions similar to those created by the recovery of the NTS loop costs through the traffic sensitive carrier common line charge. Interim Transport Rate Structure. The interim rules governing the pricing of interstate transport between LEC end offices and IXC networks include a per minute "interconnection charge" that is assessed on all persons interconnecting with the LEC switched access network. The interconnection charge is a residual amount calculated to provide LECs initially with the same level of total transport revenues under the new transport rules as they would have received under the prior rules. The interconnection charge recovers approximately seventy percent of the LECs' transport revenues. Some portion of the amount recovered through the interconnection charge represents adjustments made to the transport rate structure that reduce the level of the charge that would otherwise be assessed as the initial rate for tandem-switched transport. The remainder of the costs included in the interconnection charge presumably result from the interplay of cost allocation procedures under the separations and access charge rules. The interconnection charge is criticized because some of these costs allegedly reflect subsidies to other interstate access service segments, which affect the competitiveness of the markets for these other services. Critics argue that if a service segment is underpriced (e.g., tandem-switched transport) because of the subsidy, competitive entry into that segment of the market is more difficult. Alternatively, if the LECs' rates for a given access service are too high because they subsidize another service, uneconomic competitive entry may be encouraged in that market segment. In either case, the critics assert, the optimal allocation of market resources will not be achieved and consumers as a whole will be the losers. Finally, to the extent that some of the costs included in the interconnection charge are actually NTS in nature, recovery through a per minute pricing mechanism results in high volume users subsidizing low volume users, as occurs with the CCL charge, which may depress high volume users' demand. Other Areas to Investigate. Critics identify several distortions inherent in the current allocation process for central office equipment ("COE") maintenance expenses (for circuit equipment, switching and operator services). Among these are allocations based on total COE investment, instead of type of expense (and the resulting over recovery of COE maintenance expenses in IXC interconnection charges and under recovery in local switching and common line categories), and the uneconomic distortions caused by recovering non- traffic sensitive costs on a traffic sensitive basis. Another cost misallocation relating to COE is claimed to result from the method of counting circuit terminations in Category 4 circuit equipment allocations. This allegedly results in overallocating costs to transport and underallocating costs to special access. Critics have also complained that investments in computers LECs use to provide nonregulated interstate billing and collection services, that are included in general support facility costs, are misallocated to interstate access charges. They argue that shifting these costs to the nonregulated billing and collection category would reduce access charges. Enhanced service providers also may receive a subsidy because, under a special access charge exemption, providers of interstate enhanced services pay only the rates for local business lines to access the local exchange for their interstate traffic. This exemption enables the enhanced service providers to avoid paying the much higher, interstate access charges that would otherwise apply to that traffic. PRELIMINARY CONSIDERATIONS A Review of Telephone Subscribership Studies: Why Some Households Are Not Connected to the Network I. Overview Over the last half-century, subsidies have been an important tool used by regulators to promote the goal of universal telephone service in the United States. As one study put it, "as one looks at the historical development of the telephone system it appears that almost everything conceivable has been done to make telephone service more affordable to residential consumers through a system of transfer payments." Whether due to subsidies or to other factors, the current level of household subscribership--about 94 percent-- demonstrates significant success in the pursuit of universal service objectives. Subscribership rose dramatically from the depths of the Depression until the mid-1970s, paralleling an extended period of growth in economic activity in the United States. In 1940, 37 percent of households had telephone service. By 1983, that number had increased to 91 percent. During the last decade, however, it has become increasingly apparent that nationwide telephone subscribership has leveled off. Since 1983, total increases in overall subscribership have been small, about 2 percent to 3 percent, plateauing at approximately 94 percent. During this same period, subscribership among minorities has increased at better than double the national rate--about 6 percent. Despite the high overall rates and the apparent progress among minorities, recent studies indicate that subscribership among African-American and Hispanic households continues to lag that of White households by about 10 percent. In some demographic categories, nonsubscribership remains as high as 20 percent or 30 percent or more. Studies of subscribership rates in Washington, D.C. and New York City suggest that even with highly subsidized local service rates, significant numbers of low-income households remain off the telephone network. The emergence of competition in local exchange service will be accompanied by efforts to ensure that subsidies and support mechanisms do not distort competition. It will be important to weigh the effects of changes in subsidies made in order to promote competition upon subscribers remaining on the telephone network. In considering the rules and procedures under which competition is introduced into local service markets, particular attention should be given to whether the price and service benefits of competition will reach low-income, mobile and other populations most likely to be nonsubscribers. Recent Census-based subscribership data, and surveys of nonsubscriber attitudes and behavior regarding telephone service, suggest that: - the highest rates of nonsubscribership are among the young, the unemployed, and minority households with children; - most nonsubscribers are former subscribers, many of whom have been disconnected because of inability to pay toll charges; - the vast majority of nonsubscribers are renters and persons in non-permanent living situations; - many low-income minority households choose not to have telephone service in order to avoid being reached by the outside world. A number of state regulatory initiatives have targeted some of the primary impediments to having telephone service. These measures include: - prohibiting disconnection of local service for non-payment of toll charges; - requiring local exchange carriers ("LECs") to offer low-cost toll blocking service; - ordering streamlined procedures for reconnection. On July 20, 1995, the Commission issued a Notice of Proposed Rulemaking requesting comment on specific proposals to enhance subscribership. Several areas of inquiry addressed customer control of the long-distance use of their telephones. These included requiring LECs to offer low-cost interstate toll blocking services to block interstate calls chargeable to the subscriber, requiring reduced connection deposits for subscribers electing toll blocking options, and prohibiting disconnection of local service for failure to pay interstate toll charges. Several methods of providing service to underserved populations were raised. Voice mailboxes, low-cost centralized calling facilities, and pre-paid long- distance calling cards were suggested as possible alternatives to basic service connections for low income, highly mobile populations. Fixed cellular service and newer wireless technologies were identified as possible lower-cost alternatives to traditional wire loops for serving small populations in remote areas. The Subscribership Notice also invited comment on methods of measuring subscribership, efforts to educate consumers about available options, and streamlined procedures for determining eligibility for assistance under existing programs. Comments and reply comments were received on these proposals on September 27, 1995 and November 14, 1995, respectively. II. Profile Sketch of Households Without Telephones Analysis of the telephone subscribership information in the Current Population Survey of the U.S. Census Bureau has yielded the following profile of households without telephone service: A. Poverty - Nonsubscribership among adult heads of households between the ages of fifteen and twenty-four (15 percent) is the highest of any of the various age groups; - Nonsubscribership among African-Americans in the fifteen to twenty-four year-old group (26 percent) is nearly 75 percent higher than for the category as a whole; - Nonsubscribership among welfare and public assistance recipients is approximately 30 percent; - Analysis of census data indicates that more than two-thirds of those households without telephone service have annual incomes of $15,000 or less; - Nonsubscribership among households headed by females with children living at or below the poverty line is approximately 50 percent. B. Mobility - Nationally, renters are six times more likely than owners to be without a telephone; - In New York State, renters make up 90 percent of the households without telephones; - In a California study of areas with subscribership below 90 percent, over half of the nonsubscribers had lived at their current address for less than one year; - In the same study, after economic reasons, mobility was the most important factor determining nonsubscribership. III. Reasons Why Households Do Not Have Telephones A. Poverty Poverty, or low income, is a primary predictor of nonsubscribership. Over two- thirds of those without telephone service have annual incomes of $15,000 or less. One of the noteworthy findings in recent analyses of Census data on telephone subscribership is the very high rates of nonsubscribership among those households dependent upon public assistance: - 17.6 percent of households in subsidized housing are without telephones (an increase of close to 2 percent from ten years ago); - 31 percent of households receiving food stamps have no telephone; - 27.9 percent of households on welfare lack telephones; - 43.5 percent of households completely dependent on public assistance lack a telephone. The Link Up America and Lifeline Assistance programs provide assistance to precisely these under-served populations. B. Disconnection of Telephone Service The majority of those without telephone service once were subscribers. Of these nonsubscribers, the principal reason for nonsubscription is inability to pay toll charges. In a study of California communities with subscribership rates of less than 90 percent, 65 percent of the non-customers previously had received telephone service. This and similar studies suggest that the inability to control toll usage may be the main reason households are disconnected from the public switched network. Disconnection studies by the seven Regional Bell Holding Companies and GTE, done at the request of the Federal-State Joint Board, showed that most customers involuntarily disconnected were above-average users of toll telephone service. For example, BellSouth found that involuntarily disconnected customers in low-income areas had toll charges that were on average more than twice as high as toll charges of current customers in those areas. Some recent survey data suggest that disconnection for nonpayment of toll charges may occur disproportionately among low-income minorities. A recent study of subscribership in the District of Columbia found that the primary reason households do not have telephone service is their inability to pay the charges incurred for services used. Another recent survey of Camden, New Jersey (where African-Americans comprise 53 percent of the population and Hispanics 29 percent), found that despite their relatively lower income levels, residents of Camden consume a much higher than average amount of expensive telecommunications services and are driven from the telephone network by high usage, rather than local basic service, costs. Similarly, a survey of non-customers in California, predominantly minorities, showed that most had been disconnected voluntarily or involuntarily because of inability to control and pay for service usage. C. Mobility Mobility is highly correlated with nonsubscribership. Several studies confirm that a person in-transit is less likely to have a telephone than a long-term resident. One study of nonsubscribers in low-income areas indicates that the vast majority of nonsubscribers are renters, most have lived at their current residence for less than one year, and most of these households are below or near the poverty line. D. Privacy - Limiting Intrusion of the Outside World Two recent studies suggest that a significant number of low-income households may not subscribe to telephone service in order to avoid intrusion from unwanted sources. A recent interview survey conducted in Camden, New Jersey, focused on the reasons why households were without telephone service. Although the survey consisted of only fourteen households, the results are suggestive of attitudes among inner-city low-income households without telephones. One of the most interesting findings was that half of the households without telephones preferred cable TV service to telephone service. As reasons for making such a choice, these households cited not only a desire to avoid excess toll call usage and disconnection, but two other reasons: (1) telephones can lead to undesirable interactions involving drugs and crime; and (2) government agencies and businesses, which the study states these households view as threatening, may be able to reach the household through the telephone. Similarly, a 1993 California survey of non-customers and demographically matched customers, noted that, in this predominantly low-income population, non-English speaking Hispanics had "concerns about being reported to governmental agencies but these concerns rank well below other factors as reasons for not having phone service." The possibility that there may be a substantial number of low-income households remaining off the network by choice suggests that making telephone service more affordable may not bring these households onto the network. IV. Innovations Targeting the Sources of Disconnection As noted above, several jurisdictions have taken steps to address the impact, of disconnection for non-payment of toll charges and of cost barriers to reconnection, on subscribership rates. A. Prohibiting Disconnection of Local Service The Commonwealth of Pennsylvania prohibits disconnection of local service for non- payment of toll charges. Instead, toll calls are blocked until arrears are paid. During 1989-1992, while inner-city Washington, D.C., was experiencing a steady decline in subscribership, notwithstanding subsidy programs, our analysis of census data indicates that Philadelphia, alone among the five largest metropolitan areas in the country, experienced a dramatic increase in subscribership, from 91 percent to 97 percent. B. Low-Cost Call Blocking Services Both Maryland and the District of Columbia recently have approved low-cost tariffs for toll call blocking services. The Maryland-approved services, blocking long distance calls or 700 and 900 calls, are available to residential customers for one-time charges of $10 and $11, respectively. In the District of Columbia, two types of toll charge-restricted service are generally available. For a one-time charge of $10, and a $3 monthly fee, the call restriction service blocks origination of all direct-dial long distance calls, 700 calls, and 900 calls. The long distance message restriction service blocks those same calls and all operator ("zero") dialing for a one-time charge of $10, and a $2.50 monthly fee. Message "B" service is available to residential customers that have been or are about to be disconnected for nonpayment. Message "B" includes the toll blocking services of long distance message restriction. Customers electing message "B" service cannot subscribe to other services except Touch-Tone service, nonpublished or nonlisted service, and call trace. C. Streamlined Procedures for Assistance Procedures which make it easier to obtain subsidized connection and local service may lower reluctance of low-income households to contact telephone companies or government offices. The California Public Utilities Commission has approved a procedure allowing new subscribers to self-certify their eligibility for subsidized service. In New Mexico, participants in state public assistance programs are automatically eligible for subsidized service. D. "Quick Dial Tone" Policies "Quick dial tone" or "warm line" policies can ameliorate the effects of local service disconnection. In the state of California, disconnected customers retain access to emergency (911) services on the theory that access to emergency services is an essential service that should not be disconnected under any circumstances. V. Sources 52 PA. CODE  64.21, available in WESTLAW, Database PA-ADC (current through Master Transmittal Supplement 248 (July, 1995)). Amendment of the Commission's Rules and Policies to Increase Subscribership and Usage of the Public Switched Network, Notice of Proposed Rulemaking, 10 FCC Rcd 13,003 (1995). MTS and WATS Market Structure; 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, Second Study and Report in CC Dkt. Nos. 78-72, 80-286, 87-339, FCC 89J-3 (Joint Bd. Mar. 24, 1989). FEDERAL-STATE JOINT BOARD STAFF IN CC DKT. NO. 80-286, MONITORING REPORT MAY 1995 CC DKT. NO. 87-339 (1995). FEDERAL-STATE JOINT BOARD STAFF IN CC DKT. NO. 80-286, MONITORING REPORT SEPTEMBER 1988 CC DKT. NO. 87-339 (1988). FEDERAL-STATE JOINT BOARD STAFF IN CC DKT. NO. 80-286, MONITORING REPORT MARCH 1988 CC DKT. NO. 87-339 (1988). Bell Atlantic - Washington D.C., Inc., Local Exchange Services Tariff No. 202  2 (D.C. Pub. Serv. Comm'n, effective June 23, 1995). Bell Atlantic - Washington, D.C., Inc., General Services Tariff No. 203  6 (Supplemental Equipment) (D.C. Pub. Serv. Comm'n, effective June 17, 1994). Chesapeake & Potomac Tel. Co., Submission of Telephone Penetration Studies in Formal Case No. 850 (D.C. Pub. Serv. Comm'n, Oct. 1, 1993). Bell Atlantic - Maryland., Inc., General Services Tariff No. 203  6 (Supplemental Equipment) (Md. Pub. Serv. Comm'n, effective Oct. 1, 1994). US West Communications N.M., Exchange and Network Services Tariff  A5 (Exchange Services) (issued per N.M. State Corp. Comm'n Order in Dkt. No. 92-227-TC, effective May 15, 1993). BUREAU OF THE CENSUS, U.S. DEP'T OF COMMERCE, CURRENT POPULATION SURVEY (Nov. 1994). FCC, CC INDUS. ANALYSIS DIV., TELEPHONE SUBSCRIBERSHIP IN THE UNITED STATES (DATA THROUGH JULY 1994) (authored by Alexander Belinfante) (1994). J. Cale Case & Mark G. Ciolek, Federal Telecommunications Subsidies in the USA (Apr. 1993) (available from Palmer Bellevue Corp., 111 W. Washington St., Suite 1247, Chicago, IL 60602). Department of Telecommunications & Energy, City of N.Y., New York City Household Telephone Penetration Study, A Report on the Status of Universal Telephone Service in New York City's Neighborhoods (Nov. 23, 1993) (available from Department of Telecommunications and Energy, City of New York, 75 Park Place, 6th Floor, New York, NY 10007). [1 Non-Customer Survey] Field Research Corp., Affordability of Telephone Service (1993) (survey funded by GTE and Pacific Bell, available from Pacific Telesis, Federal Regulatory Relations, 1275 Pennsylvania Ave., Suite 400, Washington, DC 20004). John B. Horrigan & Lodis Rhodes, The Evolution of Universal Service in Texas (Sept. 1995) (available from LBJ School of Public Affairs, University of Texas at Austin, Austin, TX 78713-8925). Milton Mueller & Jorge Reina Schement, Rutgers Univ. Project on Info. Policy, Universal Service from the Bottom Up: A Profile of Telecommunications Access in Camden, New Jersey (1995) (available from Rutgers University School of Communication, Information and Library Studies, New Brunswick, New Jersey 08903). New York State Dep't of Pub. Serv., Universal Service Issues--A Staff Draft Report in Module 1 Case 94-C-0095--The Telecommunications Competition II Proceeding (May 16, 1995) (available from New York State Department of Public Service, Three Empire State Plaza, Albany, NY 12223). Scott J. Rubin, Telephone Penetration Rates for Renters in Pennsylvania (1993) (available from Pennsylvania Office of Consumer Advocate, 1425 Strawberry Square, Harrisburg, PA 17120). Jorge Reina Schement et al., Telephone Penetration 1984-1994 (Aug. 16, 1994). Telephone Interviews with Alexander Belinfante, Industry Economist, CC Indus. Analysis Div., FCC (Fall 1995 through Feb. 1996). Letter from Jerome D. Block, Chairman, New Mexico State Corporation Commission to Laurence E. Povich, Policy Analyst, CC, FCC (Mar. 20, 1995). Telephone Interview with Ann A. Dean, Regulatory Economist, Telecommunications Division, Maryland Public Service Commission (Jan. 24, 1996). Telephone Interview with Robert Loube, Director of Economics, District of Columbia Public Service Commission (Feb. 1996). Telephone Interview with Jorge Reina Schement, Associate Professor, Rutgers University School of Communication, Information and Library Studies (Mar. 1995). Telephone Interview with Corey Texeira, California Public Utilities Commission (Mar. 1995). VI. Background Sources FCC, CC INDUS. ANALYSIS DIV., REFERENCE BOOK: RATES, PRICE INDEXES, AND HOUSEHOLD EXPENDITURES FOR TELEPHONE SERVICE (authored by James L. Lande) (1994). Observations Regarding the Implications of Competition for Universal Service Issues The development of competition in local telecommunications services has two principal implications for universal service issues and concerns. First, competition has the potential to promote universal service by stimulating lower prices, improvements in facilities and technical capabilities, and innovations in pricing and service offerings. Second, competition may make it difficult to sustain the current subsidies and pricing mechanisms that were designed to support universal service in the previously monopolistic environment. This section of the report briefly addresses both of those points, as a general background to the discussion of current interstate subsidy and support mechanisms that follows. I. The Role of Competition in Promoting Universal Service General Benefits of Competition. Society benefits from competition because the incentive of an individual firm to maximize its profits is compatible with the societal economic interest in maximizing efficiency in the production and distribution of goods and services. Economists speak of the "invisible hand" of competition that directs resources into the proper markets. In a competitive environment, firms enter markets where there is the potential to earn higher than normal profits. Higher than normal rates of return signal potential entrants that consumer demand will support the demand from additional producers, and thus that entry should be profitable. Firms with production costs lower than those of the incumbent firms also anticipate profitable entry. In a competitive market, there is strong pressure for each competitor to minimize its costs, and prices are driven (down) towards marginal cost. Output expands to match demand, resulting in an efficient allocation of resources. A good example of the benefits of competition is the customer premises equipment ("CPE") market. More than twenty-five years ago, CPE was provided exclusively by LECs as part of local telephone service. In the 1960s, competitive manufacturers of CPE sought to sell their equipment directly to telephone subscribers. The Commission eventually found that there were no valid technical reasons to prohibit interconnection of competitors' CPE, and ordered that interconnection prohibitions be removed. The Commission subsequently required that charges for CPE be unbundled from local service rates and, ultimately, detariffed. After the CPE market was opened to competition, the prices of all types of telephone equipment dropped substantially. In addition, innovation by competitors in the CPE market greatly expanded the technical capabilities and the variety of CPE products available to consumers. Finally, the CPE market has experienced enormous growth. The basic phone products market (cordless telephones, corded telephones, telephone answering systems, and cellular telephones) expanded from $1.53 billion in 1984 to $4.37 billion in 1994. Potential Benefits of Competition in Local Service Competition. Universal service goals traditionally have focused on promoting telephone subscribership. More recently, it has been suggested that universal service objectives should include maximization of the availability of technologically-advanced services and facilities. New entrants in local telecommunications markets have strong incentives to develop and implement cost-efficient technology, creating pressure for the incumbent service provider to lower prices and improve service capabilities. Effective local service competition thus can promote universal service by stimulating technological advancement, lower prices, and marketing innovation. The Commission already has observed that prices are lower in cable television markets subject to competition and expects the entry of competitive access providers to lead to lower access prices in telephone markets. The very high-cost, capital-intensive nature of the local telecommunications market discourages new companies from seeking to compete with the incumbent provider. This market is unique because it is currently served by a monopolist and if a firm fails, it can not recover the significant resources that it invested to create a local network. Moreover, when a service industry moves from a regulated monopoly to a competitive market environment, there is always the possibility that new entrants may not be willing or able to serve areas where the cost of service is very high. The general assumption is that urban markets are cheaper to serve than the rural markets, and that the LECs currently use revenues from their lower-cost, urban markets to subsidize the rates for service in the high-cost, rural markets. New entrants may find that they can offer service in the urban areas at price levels significantly lower than those of the incumbent, but may not find it financially viable to offer service in the higher-cost rural areas, where prices that reflect the full cost of service may be above the LEC's subsidized rates. There is, however, some evidence that new entrants will, in fact, elect to serve at least some rural areas if a synergy is present with another existing business. For example, the Post-Newsweek Cable company has announced a strategy based on offering local telephone exchange service in rural areas. Post-Newsweek company executives reason that small rural markets may constitute a more secure market niche than the business and urban markets, where the most vigorous local service competition is likely to occur. Entering markets with low present and future competitive pressures is a well-established business practice that could encourage some competitors to offer local telecommunications services outside major metropolitan areas. II. Potential Competition in the Local Telephone Service Market While urban markets and some rural markets will readily attract competitors, the critical question is whether competition can serve the goals of universal service in markets where the incumbent providers' costs of providing service exceed the prices that customers are required to pay. In some cases, it may be unlikely that the market could generate sufficient revenues to attract a new entrant into the market. Nonetheless, competitive entry may still be possible in such markets. Economies of scale may allow local telephone companies to offer their services in an adjacent region at competitive rates; economies of scope may allow firms providing related services, such as cable television companies and electric utilities, to offer local telephone service at competitive rates. In addition, new technologies may permit new entrants to offer services at rates that are low enough to stimulate adequate demand for new service. The discussion that follows focuses on several potential sources of local service competition. A. Potential Competitors Due to Economies of Scope and Scale Cable Television Companies. The economies of scope associated with cable companies' providing both cable and telephone service may make local telephone service entry into rural area markets profitable for cable companies. In fact, Tele-Communications, Inc., Time Warner, Comcast, Cox Cable Communications, Viacom, and Continental Cablevision expect to invest over two billion dollars for the hardware and software necessary to provide telephone service over cable lines. Time Warner believes that it can deliver two lines of digital residential service at the same prices currently charged for a single line. It estimates that at a 15 percent penetration rate, revenues from telephony would generate a 25 percent pre-tax return on the incremental capital cost of telephony. In Rochester, New York, Rochester Telephone has opened its network to local telephone competition in exchange for the right to create a nonregulated business unit that could pursue new business opportunities. The approval of the New York Public Service Commission and the Federal Communications Commission allowed Rochester, New York to host the first significant test of the effects of a local cable company competing in the local telephone service market. Electric Utility Companies. Another formidable potential entrant into the local telephone service market is the electric utility industry. There could be significant economies of scope associated with providing both electric service and local telephone service. The electric utility industry is facing market changes that are similar in nature to those currently facing the telecommunications industry. The Energy Policy Act of 1992 created the potential for greater competition in the electricity market. Large power consumers currently have several viable power sources from which to select. Incumbent utility companies are now losing their monopoly positions and are looking for ways to maintain their customer base. Section 103 of the Telecommunications Act of 1996 also facilitates entry by electric utility companies. Incumbent utility companies are searching for methods to lower their costs, improve their services, and develop other revenue opportunities. These objectives can be achieved by utility companies' wiring homes to monitor electric service through a telecommunications network. The objective of this link-up is to adjust power demands constantly in a manner that reduces energy consumption. Another benefit of electric utilities' wiring homes with fiber optic cable is that energy meters can be read via computer instead of sending a meter reader to residences. Finally, a major benefit of wiring homes with fiber optic cable is that utility companies can make substantial progress toward the creation of digital telecommunications systems that can be used to provide local telephone and cable service. The Arkansas Power and Light Company believes that connecting each house it serves to its central computer will allow it to avoid building an additional 1.5 kilowatts of energy capacity per house. Based on analysis of the costs of installation against the benefits gained, as well as on the need to reduce costs in the face of impending competition in the electric market, utilities are likely to have substantial incentives to construct such a network. With this network in place, local telephone service is a logical endeavor for these utility companies. Adjoining LECs. One particularly interesting potential entrant to the local telephone service market to consider is a telephone company currently serving an adjoining service area. A firm that services an adjoining area can provide service as long as the marginal cost of service is less than the marginal revenue derived from this additional service. It may be cheaper for an incumbent firm to begin providing service to the fringes of an adjoining service area than immediately providing service for that entire service area. This raises an important point regarding competition policy. Allowing a new entrant to serve only part of a service area would increase the probability that an incumbent in an adjoining study service area would begin competitive service. In this case, we would observe competition beginning on the fringes of a service area and slowly moving towards the center of the area. B. Potential Competitors Due to Lower-Cost Technology A competitive local telephone service market may attract new entrants with lower costs. New technology may bring costs to a level that makes competitive entry in traditionally high-cost rural areas profitable. Wireless Communications. In support of its comments filed in response to the Universal Service Fund Notice of Inquiry, MCI commissioned Hatfield Associates to study the cost of providing local telephone service. The Hatfield study examines that cost in six different types of geographic areas. The Hatfield study categorizes territories according to population density per square kilometer: (1) 0 to 10, (2) 10 to 100, (3) 100 to 500, (4) 500 to 1,000, (5) 1,000 to 5,000, and (6) greater than 5,000. The study finds that it is cheaper to serve markets with population density in the ranges of 0 to 10 and 10 to 100 per square kilometer with wireless technology than it is by using wire line technology. For instance, in areas with population density in the range of 0 to 10 per square kilometer, the Hatfield study found that the monthly cost per subscriber is over $25 lower when wireless technology is used. Especially in markets with population density in the range of 0 to 10, opportunities for new entry may exist. Satellite Technology. Satellite technology also may be a viable alternative method for providing local telephone service to rural areas. US West recently began using a traditional geostationary satellite to provide telephone service to a mountainous region in Jackson Hole, Wyoming. US West is testing this service to measure the feasibility of using satellites to provide phone service in rural areas. Several cable companies that use wireless interactive digital transmission technology are entering areas currently served by wired cable systems. It is often cheaper to provide cable service with this wireless technology than with wired systems. Thus, in addition to local telephone service competition from wired cable companies, wireless cable companies may be able to compete in this market. III. The Implications of Competition for Current Subsidies and Support Mechanisms Assistance programs that provide subsidies to incumbent service providers while denying assistance to new entrants may impede the development of competition. If the incumbent LEC's service is subsidized, potential market entrants are competitively disadvantaged unless they can receive the subsidies, too. This artificial pricing advantage may mean that new entrants will decline to enter markets even if they would be able to provide service at lower costs than the incumbent provider. Subsidies directed only to the incumbent service provider in a market thus may make effective competition impossible. In that event, the disadvantaged service providers would be denied a fair opportunity to compete in the market, and telecommunications consumers would be denied the full benefits of competition. Local service competition also has significant implications for many pricing practices that were developed in the prior monopoly environment. For example, the adoption of service prices that reflect pricing principles in competitive markets may facilitate the transition from monopoly to effective competition. Under these pricing conditions, the prices of the incumbent LEC would reflect the full underlying costs of each service provided. If that occurs, then new entrants would be attracted to markets whenever they could offer service at a lower price than the incumbent LEC. Similarly, competitors may not enter those markets where their costs would be greater than the price of the incumbent LEC. Prices set on the basis of these competitive economic principles would encourage consumers to use a service that produces real benefits, because the consumer values the service above the real cost of producing the service. In the telecommunications industry, pricing services at cost-based levels frequently requires determination of whether the costs and price of a specific service are usage-based; that is, whether the costs and price vary based on how much the service is used. Services that have costs that are usage-based are called "traffic-sensitive," and those that are not usage-based are referred to as "non-traffic-sensitive" ("NTS"). When regulators require that NTS costs be recovered through usage-based (rather than flat monthly) charges, inefficient pricing signals are created that could lead to an inefficient allocation of resources. Essentially, a cost-price mismatch tends to artificially depress demand for the service when the usage-based prices are higher than would be the case for a firm operating in a competitive market. In addition, competitive distortions may occur if a regulated firm pricing in this fashion is subject to competition from new entrants who price their services on the basis of competitive economic principles. In sum, although the continued growth of competition holds great promise for further advancements in the quality and availability of telecommunications services, effective competition could be impeded by regulatory subsidy mechanisms or pricing practices that are based on the existence of a total monopoly in local telephone services. Outdated regulatory policies may serve to disadvantage new entrants, incumbent service providers, or both. The challenge lies in designing universal service support mechanisms for a competitive industry and in managing the transition to that new system. IV. Sources Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56 (1996). Implementation of Section 19 of the Cable Television Consumer Protection and Competition Act of 1992 Annual Assessment of the Status of Competition in the Market for the Delivery of Video Programming, First Report, 9 FCC Rcd 7442 (1994). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Inquiry, 9 FCC Rcd 7404 (1994). Expanded Interconnection with Local Telephone Company Facilities; Amendment of the Part 69 Allocation of General Support Facility Costs, Report and Order and Notice of Proposed Rulemaking, 7 FCC Rcd 7369, recon., Memorandum Opinion and Order, 8 FCC Rcd 127 (1992), vacated in parts and remanded sub nom. Bell Atlantic Tel. Cos. v. FCC, 24 F.3d 1441 (D.C. Cir. 1994), recon., Second Memorandum Opinion and Order on Reconsideration, 8 FCC Rcd 7341 (1993). Amendment of Section 64.702 of the Commission's Rules and Regulations (Second Computer Inquiry), Final Decision, 77 FCC 2d 384, recon., Memorandum Opinion and Order, 84 FCC 2d 50 (1980), further recon., Memorandum Opinion and Order on Further Reconsideration, 88 FCC 2d 512 (1981), aff'd sub nom. Computer & Communications Indus. Ass'n v. FCC, 693 F.2d 198 (D.C. Cir. 1982), cert. denied sub nom. Louisiana Pub. Serv. Comm'n v. FCC, 461 U.S. 938 (1983). Proposals for New or Revised Classes of Interstate and Foreign Message Toll Telephone Service (MTS) and Wide Area Telephone Service (WATS), First Report and Order, 56 FCC 2d 593 (1975), Second Report and Order, 58 FCC 2d 736 (1976), aff'd sub nom. North Carolina Utils. Comm'n v. FCC, 552 F.2d 1036 (4th Cir.), cert. denied, 434 U.S. 874 (1977). Telerent Leasing Corp., Memorandum Opinion and Order, 45 FCC 2d 204 (1974), aff'd sub nom. North Carolina Utils. Comm'n v. FCC, 537 F.2d 787 (4th Cir.), cert. denied, 429 U.S. 1027 (1976). Use of the Carterfone Device in Message Toll Telephone Service, Decision, 13 FCC 2d 420, recon. denied, Memorandum Opinion and Order, 14 FCC 2d 571 (1968). ELECTRONIC INDUS. ASS'N, CONSUMER ELECTRONIC U.S. SALES: 1990-1995 ESTIMATES. ELECTRONIC INDUS. ASS'N, 1993 ELECTRONIC DATA BOOK . Fred Dawson, MSOs Commit $2B to Branch Out into Telephony, MULTICHANNEL NEWS, Aug. 15, 1994. Joe Estrella, Wireless Co. Will Test Interactive Digital in Colo., MULTICHANNEL NEWS, Oct. 3, 1994. John M. Higgins, Post-Newsweek Goes Out into the Country, MULTICHANNEL NEWS, Sept. 26, 1994. Steven R. Rivkin, Look Who's Wiring the Home Now, N.Y. TIMES, Sept. 26, 1993,  6 (Magazine). Time Warner Focuses on Telephony, CABLE WORLD, May 9, 1994. US West Looks to the Sky for Rural Service, AMERICA'S NETWORK, Apr. 1, 1994. EXPLICIT SUPPORT MECHANISMS Lifeline and Link Up Lifeline Assistance and Link Up America promote universal service by reducing the monthly rate or initial connection charge for elderly or low-income telephone subscribers. The programs are managed by the states, and are funded through charges ultimately paid by interstate ratepayers. I. Description Lifeline: States may choose to participate in either of two Lifeline plans. Plan 1 provides for a reduction in a subscriber's monthly telephone bill equal to the $3.50 federal SLC. Half the reduction comes from a fifty percent waiver of the charge; the other half from the participating state, which matches the federal contribution by an equal reduction in the local rate. Assistance is available for a single telephone line to the principal residence of subscribers who satisfy a state-determined means test. Of the thirty-six states participating in Lifeline, only California still offers a Lifeline program under Plan 1. Under Plan 2, which expanded Plan 1 to provide for waiver of the entire SLC (up to the amount matched by the state), a subscriber's bill may be reduced by twice the SLC (or more, if the state more than matches the federal waiver). The state contribution may come from any intrastate source, including state assistance for basic local telephone service, connection charges, or customer deposit requirements. Companies in thirty-five states or territories reported subscribers receiving Plan 2 Lifeline assistance as of April, 1995. In 1994, about 4.4 million households received $123 million in Lifeline assistance through full or partial waiver of the SLC. Link Up: The Link Up America program helps low-income subscribers begin telephone service by paying half of the first $60 of connection charges. Where a LEC has a deferred payment plan, Link Up will also pay the interest on any balance, up to $200, for payment plans lasting up to one year. To be eligible, subscribers must meet a state- established means test, and may not, unless over sixty years old, be a dependent for federal income tax purposes. Link Up is available in all but two states (California and Delaware). Roughly 840,000 households received $19 million in Link Up assistance in 1994. II. History In conjunction with the divestiture of AT&T, the Commission adopted rules for the recovery of the fixed, non-traffic sensitive costs of the local telephone network. A major portion of these costs was to be collected directly from local ratepayers in a monthly flat-rate SLC. The Commission was concerned that this increase in subscribers' fixed monthly rates might drive low-income subscribers to cancel service, and asked the Federal-State Joint Board to prepare recommendations concerning the issue. On December 12, 1984, the Joint Board recommended the adoption of the first Lifeline plan: a fifty percent reduction in the SLC for subscribers satisfying a state-determined means test. On December 9, 1985, the Joint Board recommended expanding the Lifeline program. By then, however, Commission and Census Bureau studies indicated subscribership levels had not declined in response to implementation of the SLC, and were not likely to do so. (The SLC was then $1.00 per loop for residential subscribers, with an increase to $2.00 to become effective June 1, 1986.) Local telephone companies also reported stable subscribership despite significant local rate increases. The Joint Board nevertheless recommended expansion of the Lifeline program "to promote telephone subscribership among low income households." The focus of the Lifeline program had changed, and from then on, the Joint Board and the Commission emphasized active expansion, rather than mere preservation, of telephone service among low-income households. Under the new plan, which the Commission adopted December 10, 1985, qualifying subscribers could be eligible for a reduction of up to twice the SLC ($7.00 per month at present). By requiring participating states to obtain certification from the Commission before implementing the program, the new plan also strengthened the requirement to base assistance on a verifiable means test. On July 2, 1986, the Commission requested that the Joint Board examine the effects of the SLC and the Lifeline program. The Joint Board concluded that Lifeline was a sound response to concerns about low subscribership levels among low-income groups. But while endorsing the existing program, the Joint Board also recommended that the Commission "directly address the problem of high non-recurring charges for low income households that are not presently on the network, thereby not only preserving, but also increasing, universal telephone service." Specifically, the Joint Board recommended the Link Up America program: offsetting half the charge for initiating service (with a $30 cap), and paying the interest on deferred payment schedules (on up to $200, for schedules up to a year). On April 16, 1987, the Commission adopted the Link Up America plan, noting that "[w]hile we do not ordinarily propose or support subsidy programs . . . [w]e believe that this program is an appropriate means to achieve our universal service goal." To be eligible for the assistance, an applicant (i) had to live at an address that had been without service for the last three months; (ii) could not have received Link Up assistance within the last two years; (iii) could not be a dependent for federal income tax purposes (unless over age sixty), and (iv) had to meet a state-established means test. As in Lifeline Plan 2, Commission pre- certification was required. On February 27, 1989, with unanimous support from commenters, the Commission dropped the three-month residency and two-year limitation rules. III. Funding Like the much larger Universal Service Fund ("USF"), Lifeline and Link Up are funded through NECA, which disburses the subsidy to compensate local exchange carriers for SLCs not collected from end-users. NECA administers separate USF and Lifeline/Link Up pools, and IXCs contribute to each pool separately, on a flat-rate, per-line basis. At the outset of the Lifeline program, NECA assessed two categories of IXCs: those having 1 percent of all presubscribed lines nationwide; and those having 5 percent of the presubscribed lines in any given study area (with a 1,000 line minimum). These criteria produced anomalous results, however, with certain smaller IXCs concentrated in a single study area being assessed, while more diffuse, medium-sized IXCs were not. To avoid unreasonably harsh effects on small, concentrated IXCs, USF and Lifeline/Link Up assistance is now funded by the few dozen IXCs having .05 percent or more of presubscribed lines nationwide. IV. Targeting Lifeline was initially conceived to shield low-income subscribers already on the network from the effects of implementing the SLC. It developed, however, the broader purpose of expanding service to previously unserved low-income households, and Link Up America explicitly targets the unserved--those unable to afford the one-time cost of telephone connection. Both Lifeline and Link Up require state-determined means testing, and Link Up, which is available to dependents only if over age sixty, targets the elderly. Within that broad framework, the states determine eligibility. While states typically extend benefits to recipients of other social welfare services such as Food Stamps or Medicaid, some specifically target the elderly (Colorado, Hawaii, Minnesota, West Virginia); some target the disabled (Colorado, Hawaii, Idaho, Nebraska, New Hampshire); and some use a poverty level benchmark (Michigan: income at or below 130 percent of poverty; Oregon: 135 percent; California and Arizona: 150 percent). In his 1991 study, Thomas J. Makarewicz estimated how well Lifeline targets intended beneficiaries by measuring what recipients spent on the discretionary portion (long- distance calls, non-basic services) of their bills. If discretionary spending exceeded twice the Lifeline benefit, he suggested the recipient was probably a "free rider" who would maintain service even without the subsidy. Using this analysis, 80 percent of Lifeline recipients depend on the subsidy to afford telephone service, making Lifeline a narrowly targeted universal service subsidy. By contrast, studies estimate that only 8 percent to 20 percent of subscribers who benefit from USF assistance would be unable to afford the full cost of service. The discretionary spending curve of Link Up recipients closely tracks that of Lifeline recipients. V. Competitive Effect Regarding the interexchange market, Lifeline and Link Up by themselves may not cost enough to affect competition significantly; concerns about competitive distortions are more often directed at Lifeline/Link Up and USF combined. If, however, the level of support for these programs were to increase, IXCs could have a significant incentive to create subsidiaries (or small and otherwise nonviable IXCs might form) to avoid assessment. To eliminate this marketplace distortion, Ameritech has suggested bulk billing all IXCs according to market share. In the local exchange market, Lifeline and Link Up appear competitively neutral, because eligibility for the subsidy depends on characteristics of the end user, rather than on characteristics of the LEC itself. This appearance, however, may be deceptive because, under the current rules, Lifeline reimburses incumbent LECs but not competitive access providers for waiving SLCs for qualified customers, and Link Up is available for connection to wireline service only. One commenter has proposed assessing the interstate operations of LECs as well as IXCs. In response, LECs argued that an unfair double-counting of some lines would result, because exchange carriers in local access and transport areas ("LATAs") that cross state boundaries would have to contribute, while those in entirely intrastate LATAs would not. More recently, numerous parties to the Commission's USF proceeding have suggested that all carriers should contribute to funding for the Commission's assistance programs, as is currently the case with the Telecommunications Relay Services program. VI. Critique of the Subsidy Studies support a conclusion that the Lifeline Assistance and Link Up America programs are well-targeted, effective methods of expanding universal service. The combination of both programs has proven more effective than either program alone, and far more effective than Link Up alone. But some areas have been identified for improvement: o Some parties have proposed eliminating eligibility requirements that favor the elderly. A 1991 study revealed that Missouri's rules, which required that applicants be over sixty-five, targeted a population with a 95 percent subscribership level, compared to a statewide level of 91 percent. If the criterion had been that applicants receive some sort of income assistance, the subscribership among those eligible would have been 78 percent. Texas, with a similar age rule, showed similar results: 91 percent of the targeted group (age sixty-five and over) already subscribed, compared to 89 percent statewide and 71 percent if the criterion had been income assistance. By contrast, heads of household between sixteen and twenty-four have the lowest subscription rate, and are most likely to discontinue service. o Others express concern regarding the correlation between the receipt of Link Up assistance and uncollectible revenues. A rough correlation exists between Link Up subscribers and non-payment of long-distance bills. The correlation is especially marked in states with a deposit waiver program. Companies in those states had approximately ten times as many written-off accounts as companies in states that require a deposit. Blocking long-distance calls on lines with payment in arrears (as opposed to discontinuing service altogether) suggests itself as a possible solution to the "disconnect-reconnect" cycle. o Low participation is another concern. A 1991 study found that only approximately 10 percent of eligible households in Texas and Arkansas received assistance; in Missouri, 60 percent of eligible households received assistance. The disparity might reflect differences in the targeted populations, including how widely it is known that assistance is available, or may reflect general variances in state social service systems. VII. Sources 47 C.F.R.  36.701-36.741, 69.104(j)-(l), 69.116, 69.117, 69.203(f)-(g). Amendment of Part 69 of the Commission's Rules Relating to the Assessment of Charges for the Universal Service Fund and Lifeline Assistance, Memorandum Opinion and Order, 4 FCC Rcd 6134 (1989). MTS and WATS Market Structure LINK UP AMERICA, and Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Decision and Order, 4 FCC Rcd 3634 (1989). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Report and Order, 2 FCC Rcd 2953 (1987). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Further Notice of Proposed Rulemaking in CC Dkt. Nos. 78- 72, 80-286, FCC 86-305 (July 2, 1986) (summarized in 51 Fed. Reg. 27,426 (1986)). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Decision and Order, 51 Fed. Reg. 1371 (1986). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Decision and Order, 50 Fed. Reg. 939 (1985)]. MTS and WATS Market Structure Phase IV, Further Report on the Effects of Federal Decisions on Universal Service in CC Dkt. No. 78-72, FCC 84-636 (Jan. 4, 1985). Petition of the State of Michigan Concerning the Effects of Certain Federal Decisions on Local Telephone Service, Order, 96 FCC 2d 491 (1983). MTS and WATS Market Structure, Third Report and Order, 93 FCC 2d 241, modified on recon., Memorandum Opinion and Order, 97 FCC 2d 682 (1983), modified on further recon., Memorandum Opinion and Order, 97 FCC 2d 834, aff'd in principal part and remanded in part sub nom. National Ass'n of Regulatory Util. Comm'rs v. FCC, 737 F.2d 1095 (D.C. Cir. 1984), cert. denied, 469 U.S. 1227 (1985). MTS and WATS Market Structure LINK UP AMERICA, and Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 4 FCC Rcd 1219 (Joint Bd. 1989). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 2 FCC Rcd 2324 (Joint Bd. 1987). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 50 Fed. Reg. 52,964 (Joint Bd. 1985). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 49 Fed. Reg. 48,325 (Joint Bd. 1984). Comments of Ameritech, MCI, NYNEX, Rochester Tel. Corp., and Sprint, to the Notice of Inquiry in CC Dkt. No. 80-286 (responding to Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Inquiry, 9 FCC Rcd 7404 (1994)). FEDERAL-STATE JOINT BOARD STAFF IN CC DKT. NO. 80-286, MONITORING REPORT MAY 1995 CC DKT. NO. 87-339 (1995). FEDERAL-STATE JOINT BOARD STAFF IN CC DKT. NO. 80-286, MONITORING REPORT MAY 1994 CC DKT. NO. 87-339 (1994). Herbert S. Dordick & Marilyn Diane Fife, Universal Service in Post-Divestiture USA, 15 TELECOMM. POL'Y 119 (1991). Thomas J. Makarewicz, The Effectiveness of Low-Income Telephone Assistance Programmes: Southwestern Bell's Experience, 15 TELECOMM. POL'Y 223 (1991). J.L. Walter, Assessing the Effectiveness of Residential Rate Assistance Programs in Furthering the Goal of Universal Service, in PROCEEDINGS OF THE EIGHTH BIENNIAL REGULATORY INFORMATION CONFERENCE 171 (1992). Organization for the Protection & Advancement of Small Tel. Cos., Keeping Rural America Connected: Costs and Rates in the Competitive Era (1994) (available from OPASTCO, 21 Dupont Circle, N.W., Suite 700, Washington, D.C. 20036). Carol Weinhaus et al., Telecommunications Indus. Analysis Project, What Is the Price of Universal Service? Impact of Deaveraging Nationwide Urban/Rural Rates (1993) (available from Telecommunications Industries Analysis Project, Meeting House Offices, 121 Mount Vernon St., Boston, MA 02108). VIII. Background Sources MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Memorandum Opinion and Order on Reconsideration and Order Inviting Comments, 3 FCC Rcd 4543 (1988). National Telecomm. & Info. Admin., U.S. Dep't of Commerce, Inquiry on Universal Service and Open Access Issues, Notice of Inquiry in Dkt. No. 940955-4255, 59 Fed. Reg. 48,112 (1994). Telecommunications Relay Services (TRS) for Hearing-Impaired Telecommunications Users I. Description Telecommunications Relay Services are services that provide persons with hearing or speech impairments the ability to communicate by telephone in a manner "functionally equivalent" to the ability of persons without such impairments. Currently, TRS involves the use of a text telephone ("TTY") by a hearing-impaired or speech-impaired caller to communicate by telephone with persons who do not have such impairments. TRS facilities have specialized equipment and staff who relay conversations between persons using TTYs and persons who use conventional telephones. To access TRS, a caller must connect the TTY to the telephone line through the acoustic coupling device on the TTY or directly to the telephone line. The caller then dials a preassigned 800 number to reach the local TRS center. The caller communicates with one of the center's communications assistants ("CA") by typing information into the TTY. The CA in turn places a voice call to the called party. The CA serves as a critical link in the conversation by converting all TTY messages from the caller into voice and all voice messages from the called party into typed text for the TTY user. The CA can perform the process in reverse when a person without a hearing or speech impairment initiates the call. TRS services, which began in the states in the mid-1980s, became a requirement under federal law with the enactment of the Americans with Disabilities Act of 1990 ("ADA"). Among other requirements, the ADA requires that "users of telecommunications relay services pay rates no greater than the rates paid for functionally equivalent voice communication services with respect to such factors as the duration of the call, the time of day, and the distance from point of origination to point of termination." In a series of orders, beginning with amendments to its Part 64 rules in July 1991, the Commission adopted rules that require the provision of TRS, set minimum standards for TRS providers and specified procedures for certification of state TRS programs. The Commission also established a shared-funding mechanism ("TRS Fund") for recovering the costs of providing interstate TRS and named NECA as the fund administrator. The Commission's rules require all interstate telecommunications companies, data as well as voice, to contribute to the TRS Fund. Contributing companies include, but are not limited to, LECs, IXCs, cellular telephone and paging companies, personal communications services, resellers, 900 services, and satellite, video, and paging providers. These carriers contribute annually to the TRS Fund based on a factor calculated by NECA and approved by the Commission. The factor is applied to the companies' gross interstate revenues. Currently, approximately 2,850 carriers contribute .03 percent of their gross revenues to fund TRS, and the size of the fund is approximately $30 million. NECA then distributes the contributed TRS funds monthly to eligible TRS providers based on a compensation rate (again, calculated by NECA and approved by the Commission) applied to provider-reported interstate TRS minutes-of-use. Recently, NECA reported to the Commission that the proposed January 1, 1996 compensation rate should be $1.379 per minute, an increase from the previous rate of $1.304 per minute. In summary, TRS is a subsidy program because it recovers at least some of its operating costs from sources other than those who actually cause them. II. History The ADA requires the Commission to ensure that every common carrier makes interstate and intrastate TRS available to the extent possible and in the most efficient manner to hearing-impaired and speech-impaired persons in their service areas. To carry out this mandate, the Commission, in a July 1991 order, amended its Part 64 rules to establish minimum standards for TRS providers and specified procedures for certification of state TRS programs that had been in existence since the mid-1980s. Subsequently, in February 1993, the Commission issued an order that required all interstate voice telecommunications carriers to offer TRS throughout their service areas by July of that year. The Commission's order also proposed a shared-funding mechanism for interstate TRS, administered by NECA. Later, the Commission's July 1993 order imposed annual reporting and fund contribution obligations upon all interstate carriers, and named NECA as administrator for an interim two-year term. In that order, the Commission also directed NECA to establish an interstate TRS advisory council. The council, which advises NECA on interstate TRS cost recovery matters, includes representatives of the hearing- impaired and speech-impaired communities, interstate communications providers, TRS providers, TRS users, and state telephone regulators. A September 1993 Commission order contained the TRS provider payment formula, initial fund requirements, and administration schedule. Since then, NECA has administered TRS funding, including calculating the annual percentage of revenue contributed by interstate providers, and the cost reimbursement to which TRS providers are entitled. In June 1995, the Commission reappointed NECA as TRS administrator for a four-year term and expanded the advisory council. III. Competitive Effect Recognizing that the customers of all interstate communications providers (e.g., LECs, IXCs, resellers) provide TRS funding, it would not appear that one interstate carrier or customer is placed at a competitive disadvantage by the action of another. This, of course, assumes that all interstate carriers pass the same proportion of their TRS fund costs on to their customers. Because interstate calling varies greatly among customers, however, high-volume interstate users support a greater portion of interstate TRS costs than occasional interstate users do. Many would argue that this is how it should be using pure cost causation principles. IV. Critique of TRS Funding Most critics of TRS have focused on the process and need for funding, rather than the concept of providing TRS services to persons with hearing or speech impairments. Two critics, Cellular Telecommunications Industry Association ("CTIA") and AT&T initially favored self-funding TRS. Self-funding, argued CTIA and AT&T, would eliminate significant administrative costs. The Commission, however, agreed with the majority of commenters who believed "that a self-funding mechanism would provide incentives for carriers to handle fewer relay calls, to degrade relay calling quality, [encourage relay customers] to migrate . . . to other carriers, and to restrict relay [service] to only their presubscribed customers." V. Positions of Major Interest Groups Following the Commission's TRS III order, which finalized the current shared-funding mechanisms for interstate TRS, Ameritech, NYNEX, and SWB filed petitions requesting the Commission to reconsider the definition of gross revenues, used for TRS contributions, to exclude interstate access revenues. In TRS IV, the Commission rejected this proposal, but allowed exogenous treatment of TRS contributions for price cap carriers. Several commenters responding to the Commission's August 30, 1994 Notice of Inquiry concerning high cost assistance issues suggested replacing the current method of supporting that assistance with a bulk billing funding scheme similar to the one used for TRS. VI. Sources Americans with Disabilities Act of 1990, Pub. L. No. 101-336, sec. 401(a), 104 Stat. 327, 366 (1990) (codified at 47 U.S.C.  225). 47 C.F.R.  64.601(6), (9), 64.604(c)(4). Telecommunications Relay Services, and the Americans with Disabilities Act of 1990, Second Order on Reconsideration and Fourth Report and Order, 9 FCC Rcd 1637 (1993). Telecommunications Relay Services, and the Americans with Disabilities Act of 1990, Third Report and Order, 8 FCC Rcd 5300 (1993). Telecommunications Services for Individuals with Hearing and Speech Disabilities, and the Americans with Disabilities Act of 1990, Order on Reconsideration, Second Report and Order, and Further Notice of Proposed Rulemaking, 8 FCC Rcd 1802 (1993). Telecommunications Services for Individuals with Hearing and Speech Disabilities, and the Americans with Disabilities Act of 1990, Report and Order and Request for Comments, 6 FCC Rcd 4657 (1991). Telecommunications Relay Services, and the Americans with Disabilities Act of 1990, Order in CC Dkt. No. 90-571, DA 95-2475 (rel. Com. Car. Bur. Dec. 14, 1995). The Universal Service Fund I. Description The Universal Service Fund uses the Commission's jurisdictional separations rules to provide assistance to LECs with higher-than-average local loop costs. LECs' local loop costs vary widely due to many factors, including subscriber density, terrain, the size of local exchanges, and labor costs. The Commission's rules define a basic allocation factor of 25 percent to govern the allocation of NTS costs to the interstate jurisdiction. Pursuant to that rule, a LEC may allocate 25 percent of its NTS costs, including local loop costs, to the interstate jurisdiction. The USF provides an additional subsidy to LECs operating in high-cost areas. The USF allows LECs with local loop costs above 115 percent of the nationwide average for such costs to allocate additional amounts of their local loop costs to the interstate jurisdiction. LEC study areas with fewer than 200,000 loops receive assistance for a greater percentage of their above-average loop costs than is the case for larger study areas. The Commission's purpose in adopting the USF rules was to promote universally available telephone service at reasonable rates. Absent the USF assistance mechanism, the costs currently allocated to the USF would need to be recovered by increasing intrastate charges, particularly charges for local telephone service. The Commission adopted the USF rules to promote telephone subscribership by providing financial assistance to prevent extremely high local rates in high-cost areas. Targeting. Unlike the Lifeline Assistance and Link Up America programs, which target assistance to individual subscribers, the USF program provides assistance to LECs operating in high-cost areas. There are two primary reasons for this different focus. First, the Commission based the USF on its broad mandate "to make available, so far as possible, to all the people of the United States a rapid, efficient, Nation-wide and world-wide wire and radio communication service with adequate facilities at reasonable charges." Second, the USF and the basic allocation factor replaced a system of jurisdictional separations that provided a general subsidy to local telephone service by allocating NTS costs to interstate toll service. Funding. The USF is funded through a tariffed interstate charge paid by IXCs, and based on the number of subscriber lines presubscribing to that carrier. IXCs with fewer than .05 percent of presubscribed lines nationwide are exempt. At present, the .05 percent threshold means that those carriers with more than approximately 72,000 lines (30 of the 424 IXCs) contribute to the fund. Each year, NECA collects information from each LEC study area regarding the carriers' loop costs and number of working loops. NECA then calculates the total amount of USF assistance needed for the next year and, accordingly, prepares USF tariffs designed to recover that amount from the contributing IXCs during the annual rate period. In 1993, the total USF assistance was $705.1 million. Contributing IXCs paid about $.46 per line per month into the fund. At the end of 1993, the Commission adopted a two-year indexed cap on the level of the USF. The Commission recently extended this cap through July 1, 1996. Under the cap, the rate of annual USF growth cannot exceed the previous year's rate of growth in the total number of working loops nationwide. In 1994, the USF was $725.4 million and in 1995, the USF was $749.5 million. USF payments in 1996 will be $734.6 million. II. History The concept behind establishment of the USF arose in 1982, as an outgrowth of proposed revisions to the jurisdictional separation of NTS exchange plant costs. The subscriber plant factor ("SPF"), the usage-based factor then used to allocate NTS costs between the interstate and intrastate jurisdictions, provided an interstate subsidy to local telephone operations. By 1982, SPF was causing increasing percentages of those costs to be allocated to interstate operations, and the Commission wished to consider replacing SPF with fixed allocation factors. The Joint Board Staff ("Staff") urged that the successor to SPF be designed to reflect "the special needs of high cost areas," many of which had high interstate allocations under SPF. The Staff believed that without such adjustments for high-cost companies, those LECs would experience major shifts of NTS costs to their intrastate operations, causing large increases in local telephone rates. The Commission therefore proposed to replace SPF with three new factors: a basic allocation factor; a high-cost factor to provide assistance to areas with high costs; and a transition factor "to minimize dislocations caused by moving away from the existing SPF basis." In developing an appropriate replacement for SPF to allocate NTS local exchange plant, the Joint Board recommended "an equal percentage interstate allocation of NTS local exchange plant costs for all study areas in conjunction with appropriate protection for subscribers in high cost areas." The Joint Board proposed, and the Commission adopted, as the replacement for SPF, a 25 percent basic interstate allocation factor for NTS exchange plant costs. In addition, the Joint Board recommended the establishment of a banded high-cost support mechanism designed to provide a greater degree of assistance to LECs with the highest average NTS costs. The Joint Board suggested a transition period for phasing out SPF and phasing in the new basic allocation factor and high-cost factor. The Joint Board determined that a high-cost support mechanism would "help protect the nationwide availability of telephone service at reasonable rates while limiting the amount to be recovered through carrier's carrier access charges." The Commission found that the methodology recommended by the Joint Board represented "a sound balancing of concern for the promotion of universally available telephone service at reasonable rates and the need to prevent uneconomic bypass of the local exchange." The Commission therefore adopted the high-cost support mechanism recommended by the Joint Board. Concurrently with proceedings to revise the jurisdictional separation of NTS exchange costs, the Commission considered the adoption of interstate exchange access charges. At that time, parties expressed much concern regarding the effect of the federal subscriber line charge ("SLC") upon customers of small telephone companies. As a result, the Commission deferred the effective date of the federal SLC while the Joint Board considered a means of "increasing the assistance that is provided to customers of small companies in high cost areas through the Universal Service Fund." After further proceedings, the Joint Board recommended that the Commission establish a two-tiered system of assistance, whereby USF assistance would be increased for LEC study areas with fewer than 50,000 loops and decreased for study areas with more than 50,000 loops. The Commission adopted the Joint Board's recommendation. In 1986, the Commission undertook an examination of the "cohesive package" of SLCs, lifeline programs, and high-cost assistance measures. The Commission asked parties to evaluate the effects of those three mechanisms and to consider whether revisions were needed in order to preserve universal service, promote economic efficiency, eliminate service pricing discrimination, and deter uneconomic bypass. After considering the comments and proposals submitted in response to the Commission's 1986 Notice, the Joint Board recommended, and the Commission adopted, a retargeting of the high-cost assistance measures provided to telephone companies with high-cost study areas. Assistance to study areas with fewer than 200,000 loops was increased while assistance to larger study areas was decreased. The Joint Board premised its recommendation on an assumption that small companies have more need for assistance than larger LECs, which were believed to have greater flexibility in how they recovered above-average costs. There was also evidence that the retargeting of the high-cost measures would decrease the overall size of the USF significantly. Both the USF and the 25 percent basic interstate allocation factor for NTS exchange plant costs were phased-in over a transition period lasting several years. Over the transition period, the basic allocation factor, supplemented by the USF factor for high-cost study areas, gradually replaced SPF. During 1993, the final year of the transition, both the 25 percent basic interstate allocation factor and the USF assistance factor had completely replaced SPF. During that period, however, significant changes had occurred in the technological capabilities and costs, market structure, and regulation of the telecommunications industry. The Commission faced the possibility that the USF assistance mechanism first adopted in 1984 was no longer suitable in the current marketplace. At the least, it appeared that evaluation of the effects and effectiveness of the current rules should be undertaken. Accordingly, the Commission announced in late 1993 that it intended to undertake examination and re-evaluation of the USF assistance rules. Moreover, because growth in the USF had been inexplicably erratic throughout the transition period, the Commission proposed to control USF growth while the rules are under review. The Joint Board subsequently recommended, and the Commission adopted, an indexed cap on USF growth that now extends through July 1, 1996. This cap limits annual USF growth to the percentage of growth in the total number of working loops nationwide during the previous year. In August 1994, the Commission released a Notice of Inquiry inviting "commenters to address the appropriate level and targeting of high-cost assistance and to evaluate the relationship between high-cost assistance and the development of competition in local services." The Notice invited commenters to evaluate two broad approaches to the present high-cost mechanisms. The first approach would base high-cost assistance on costs reported by the local service provider, as is the case with the current USF rules; the second would base high-cost assistance upon the application of proxy factors designed to reflect general cost characteristics and economic conditions. After reviewing the comments submitted in response to the Notice of Inquiry, the Commission issued a Notice of Proposed Rulemaking and Notice of Inquiry on July 13, 1995. The Commission's proposals for revising USF assistance are discussed in part IV, below. III. Critique of the Subsidy Parties criticize the current rules for USF eligibility because they provide little or no incentive for many high-cost carriers to invest efficiently in their local loop plant. High cost areas with less than 200,000 working loops are able to allocate 90 percent to 100 percent of their incremental loop costs to the interstate jurisdiction. The USF therefore offers these high-cost carriers no incentive to invest efficiently because incremental loop plant investments are fully funded by the USF, thereby sparing the companies' investors the normal risks of investment. A second critique of the USF assistance mechanism is that it tends to serve as a barrier to entry into the local service market. The current USF rules grant assistance only to the qualifying incumbent LEC service provider. Would-be market entrants may complain that USF assistance allows LEC recipients to price their local services at below-cost levels that potential competitors, without access to USF assistance, may be unable to meet. With the current USF rules in place, potential local competitors often may find it impossible to price their services at levels that are competitive with those of the incumbent LEC, even if the competitor's underlying costs are significantly lower. IXCs and others criticize the total level of the USF as too high, maintaining that the total subsidy level exceeds that needed to maintain universal service. Moreover, many parties have argued that the USF is too untargeted, subsidizing users who are able to pay the full cost of local service, as well as those individuals who could not afford telephone service but for the availability of an interstate subsidy. They point out that interstate toll users, regardless of their individual income levels, bear the costs associated with providing local service to a significant number of subscribers who do not need assistance. Parties criticize the method of funding the USF. Many members of the telecommunications industry believe that the IXCs should not bear the entire responsibility for funding USF assistance, and that other carriers should be required to contribute to the cost of maintaining universal service. In addition, AT&T objects to the basis for determining each IXC's contribution, arguing that recovering USF costs from IXCs on the basis of presubscribed lines is unfair because many subscriber lines generate little or no toll revenue for the IXC to which the line is presubscribed. Finally, parties with a variety of interests (IXCs as well as State regulators) call for the designation of a neutral administrator of the USF. They maintain that administration of the current system is tainted by the fact that the administrator, NECA, also functions as a trade association and representative of the LEC industry. Those critics argue that NECA may have inadequate incentives to scrutinize carefully the costs and other information reported by USF recipients. IV. Proposals for Changing or Replacing the Subsidy The Commission's July 13, 1995 Notice of Proposed Rulemaking and Notice of Inquiry requested comment on three specific proposals for revising USF assistance. As an adjunct to any of the three proposals, the Commission proposed a system of high-cost credits to direct assistance to carriers chosen by customers. A. Proposal 1: High-Cost Assistance Based on Actual Costs Reported by LECs The first proposal outlined three alternatives, each of which would continue to base high-cost assistance on actual costs reported by the LECs: (1) retaining the current structure with some adjustments; (2) allocating high-cost assistance to large LECs through a high-cost credit system; and (3) basing high-cost assistance on a combination of both loop and switching costs. 1. Retaining the Current Structure with Some Adjustments. The Commission proposed extending indefinitely the two-year interim cap on the total level of the USF, raising the current average local loop cost threshold from 115 percent to about 129 percent of the nationwide average for such costs, and eliminating assistance to those LECs receiving less than one dollar per line per month. In addition, the extra high-cost assistance provided to small study areas would be either completely eliminated or significantly restricted in amount (by both lowering the maximum percentage of incremental loop costs allocable to the interstate jurisdiction) and availability (by reducing by one-half the maximum number of loops in the largest study area qualifying for the extra assistance). Although the proposal does not specify how high-cost credits would be used with this alternative, high-cost credits would be available to customers in all eligible areas, whether served by large or small LECs. 2. Allocating High-Cost Assistance to Large LECs Through a High-Cost Credit System. Under this alternative the interim cap on the total level of the USF would be extended indefinitely. High-cost assistance would be allocated to each study area based on reported costs. In areas served by small LECs, assistance would be distributed directly to the carrier, as is the case under the current rules. However, assistance would be distributed through high-cost credits in areas served by large LECs. Within study areas served by large LECs, the high-cost credits would be targeted toward sparsely populated regions. 3. Basing High-Cost Assistance on a Combination of Both Loop and Switching Costs. Under this alternative, switching and loop costs for each study area would be associated with either local service or toll service. The Commission proposed a uniform allocation of loop costs for all LECs: 25 percent to the interstate jurisdiction, 25 percent to intrastate toll services, and 50 percent to local service. The fraction of switching costs allocated to local service would be in the same ratio as local minutes of traffic to total minutes of traffic flowing through the switch. Study area high-cost assistance, based on the average combined switching and loop costs associated with local service, would be distributed following any of the methods described in the first two alternatives. B. Proposal 2: High-Cost Assistance Based on Proxy Factors Under the second proposal, high-cost assistance would be distributed on the basis of proxy factors related to the costs of providing services, rather than actual reported costs. The Commission stated that basing assistance on area characteristics associated with high costs, rather than on incurred costs, would provide incentives to control costs and would further competition among disparate providers. The Commission suggested several tentative proxy factors and requested comments on their reliability, competitive neutrality, and utility in projecting service costs. The Commission proposed basing assistance on analysis of the projected service costs of smaller, more homogenous areas than the much larger study areas currently used to determine assistance, and invited comment on appropriate engineering models that would be used to project reasonable service costs from the proxy factors describing the areas to be served. C. Proposal 3: Commission Certified State Plans for Distributing High-Cost Assistance Under this proposal, assistance would be allocated first among the States; then State utility commissions would decide the distribution of assistance among the carriers serving a State, using plans developed pursuant to general Commission guidelines and reviewed by the Commission. Allocation among the states would be accomplished using a simplified subset of the proxy factors described in the second proposal discussed under IV.B. Comments were specifically invited "on [Commission] guidelines that would promote universal service and maximum subscribership, while preventing [State] distribution plans that would act as barriers to competition." D. High Cost Credits High-cost credits are intended to reduce barriers to competitive entry in the local service environment by giving new market entrants, as well as incumbent LECs, access to high-cost assistance. These credits could be adopted as part of any of the three proposals discussed above. The Commission noted that high-cost credits might be unnecessary in those areas where no competitive entry had occurred, and invited comment on whether assistance should be limited to areas where the existence of competition was established. The Commission proposed defining assistance levels and analyzing service costs within Census Block Groups ("CBGs") defined by the Census Bureau, rather than the much larger study areas currently used to determine USF assistance, to discourage attempts to cross-subsidize service in competitive markets using high-cost assistance. In response to concerns that incumbent LECs, unlike competitive carriers, were not free to choose among potential customers but offered basic service to all, the Commission proposed minimum basic service and maximum basic rate requirements on carriers as a condition of eligibility for assistance. Finally, the Commission invited comment on the question of whether assistance should be based in whole or in part on the financial needs of the particular customers served. V. Positions of Major Interest Groups Large LECs. Large LECs maintain that changes in the distribution of USF assistance must be accompanied by other changes. They emphasize revision of the current funding mechanisms for USF subsidies, elimination of the carrier common line charge and other internal subsidies, and the need for LEC pricing flexibility. The large LECs generally argue that the USF should be funded by all telecommunications carriers, not just IXCs. They object to making USF assistance available to deploy advanced services and facilities, suggesting instead that assistance should only be available to support basic telephone service. Bell Atlantic, Pacific Bell, and US West contend that USF assistance should be available to owners of large as well as small study areas, but NYNEX maintains that price cap LECs should not receive high cost support because it is inconsistent with the underlying premise of the price cap system. The large LECs would have the Commission consider a proxy approach to calculate high cost assistance, with some (e.g., US West) strongly supporting the use of proxy factors. Some large LECs (e.g., NYNEX, Cincinnati Bell, Rochester) maintain that USF assistance should be limited to the carrier of last resort (i.e., the incumbent LEC) in each service area, while others (e.g., Ameritech) support the concept of a customer voucher or credit system. Mid-Size LECs. Mid-size LECs contend that USF assistance should be available to support deployment of technologically-advanced services. They generally oppose the use of proxy factors or customer vouchers, maintaining that proxy factors cannot reflect the wide variations in costs among LECs and that vouchers would deter infrastructure development in high cost areas. The exception among mid-size LECs is Citizens Utilities Company, which supports consideration of proxy factors for determining USF assistance and proposes a virtual voucher methodology that would afford contribution credits to eligible residential customers. One mid-size LEC, Virgin Islands Telephone Corporation, advocates that companies with below-average rates or above-average rates of return be ineligible for USF assistance. Small LECs. Small LECs, almost without exception, strongly support the existing USF rules and oppose any change whatsoever. The only change that a few LECs concede would be acceptable is further limitation on the eligibility of large LECs for USF assistance. One small LEC (Mid-River Telephone Cooperative) suggests that price cap LECs could be excluded, and others propose excluding LECs with more than 50,000 (Golden West Communications) or 100,000 (e.g., Taconic, Telephone Electronics Corporation) access lines. Small LECs strongly oppose the use of proxy factors and customer vouchers, and they argue that USF assistance should be provided only to a single carrier of last resort in each area. Some small LECs (e.g., Blanca Telephone Company, Kalona Cooperative Telephone Cooperative, Ketchikan Public Utilities) support the USTA definition of universal service as including voice grade access to the public switched network, single-party, TouchTone service, white page listing, access to operator services and directory assistance, averaged toll rates, and access to emergency services (e.g., 911). OPASTCO, however, argues that the concept of universal service must include signalling system seven, deployment of digital and broadband technology and other advanced services as they become generally available to the public. One notable dissenter from the general support for the existing rules is Smithville Telephone Company, which advocates the initiation of strict auditing requirements and penalties for violations. IXCs. Some IXCs maintain that all telecommunications carriers, not just IXCs, should be required to fund USF high-cost assistance. If the USF assistance continues to be based on actual costs, most IXCs support increasing the threshold for assistance (e.g., from 115 percent to at least 130 percent, General Communication, Inc.) and reducing the maximum assistance level (e.g., from 75 percent to 50 percent, AT&T). Some IXCs oppose USF assistance for price cap and Tier 1 LECs (GCI argues that the access line cut-off should be reduced to 50,000 access lines). Some IXCs (e.g., CompTel, LDDS) propose that recipients be required to demonstrate that their subscribers pay higher than average local rates. Some IXCs suggest that the Commission adopt safeguards against abuses, including benchmarking LEC costs, undertaking audits, and setting up a neutral third-party administrator. IXCs generally support the use of a voucher system for delivering USF assistance. Competitive Access and Local Service Providers. Local service competitors contend that the current subsidy mechanisms serve as barriers to competitive entry and advocate the use of a competitively neutral subsidy mechanism, such as customer vouchers. The Association for Local Telecommunications Services ("ALTS") further advocates that all competing providers should contribute to funding of subsidy mechanisms and should be eligible for receipt of assistance. ALTS also argues that Tier 1 LECs should not receive assistance. The local competitors generally support the concept of proxy factors for determining the appropriate assistance levels. MFS proposes that basic local rates be capped in areas where high cost subsidies are received. Teleport suggests that the Commission should make several changes in the USF immediately by increasing the threshold for assistance, lowering the maximum access line requirements, paying support only on residential lines, adjusting the sliding cost scales, and continuing to index the fund to control its growth. Teleport further suggests that the Commission should undertake a second phase to begin a more comprehensive investigation of universal service and the need for long-term changes in the subsidy mechanisms, such as a means of delinking universal service from the revenue requirements of the incumbent LECs. State Commissions. The State commissions have taken diverse positions on these issues. The Wyoming PSC and the Virgin Islands PSC oppose any change to the current rules, which they believe have worked well. The Alabama PSC, the North Carolina Utilities Commission, and the Vermont Department of Public Service oppose any changes than would reduce the current level of USF support. The California PUC, the New York DPS, and the Pennsylvania PUC support the use of proxy factors because they believe that the current rules do not provide sufficient incentives for USF assistance recipients to operate efficiently. The concept of customer vouchers received mixed reviews, with the California PUC and Pennsylvania PUC supporting the concept, the Alaska PUC and Wyoming PSC opposing it, and the Alabama PSC, Vermont DPS, and Virgin Islands PSC uncertain. Finally, several commissions (California PUC, New York DPS, Pennsylvania PUC, North Carolina UC, and Vermont DPS) support the proposal to give State commissions a role in administering USF high cost assistance within their States. VI. Sources 47 U.S.C.  151. 47 C.F.R.  36. 47 C.F.R.  69.116(a). 47 C.F.R.  67.124(d), 67.641 (1986). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Report and Order in CC Dkt. No. 80-286, FCC 95-494 (rel. Dec. 12, 1995). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Proposed Rulemaking and Notice of Inquiry, 10 FCC Rcd 12,309 (1995). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Inquiry, 9 FCC Rcd 7404 (1994). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Proposed Rulemaking, 8 FCC Rcd 7114 (1993). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Report and Order, 9 FCC Rcd 303 (1993). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Report and Order, 2 FCC Rcd 2953 (1987). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Further Notice of Proposed Rulemaking in CC Dkt. Nos. 78- 72, 80-286, FCC 86-305 (July 2, 1986) (summarized in 51 Fed. Reg. 27,426 (1986)). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Decision and Order, 50 Fed. Reg. 939 (1985). Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Decision and Order, 96 FCC 2d 781 (1984). MTS and WATS Market Structure, Memorandum Opinion and Order, 97 FCC 2d 834, aff'd in principal part and remanded in part sub nom. National Ass'n of Regulatory Util. Comm'rs v. FCC, 737 F.2d 1095 (D.C. Cir. 1984), cert. denied, 469 U.S. 1227 (1985). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Further Notice of Proposed Rulemaking, 49 Fed. Reg. 18,318 (1984). Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Decision and Order, 89 FCC 2d 1 (1982). Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Order Requesting Further Comments, 47 Fed. Reg. 54,479 (1982). Commission Requirements for Cost Support Material to Be Filed with 1993 Annual Access Tariffs, Order, 8 FCC Rcd 1936 (Com. Car. Bur. 1993). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision, 9 FCC Rcd 334 (Joint Bd. 1993). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 2 FCC Rcd 2324 (Joint Bd. 1987). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 49 Fed. Reg. 48,325 (Joint Bd. 1984). Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Second Recommended Decision and Order, 48 Fed. Reg. 46,556 (Joint Bd. 1983). Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Interim Order, 46 Fed. Reg. 63,354 (Joint Bd. 1981). NECA Tariff FCC No. 5, Presubscribed Lines by Qualified Interexchange Carrier (Nov. 14, 1994). NECA Tariff FCC No. 5, Access Service, 17.1.4(B) (Dec. 28, 1992; May 17, 1993). FEDERAL-STATE JOINT BOARD STAFF IN CC DKT. NO. 80-286, MONITORING REPORT MAY 1995 CC DKT. NO. 87-339 (1995). Dial Equipment Minutes (DEM) Weighting I. Description Part 36 of the Commission's rules for jurisdictional separations allocates investment costs of local switching equipment between the interstate and intrastate jurisdictions by the use of the relative dial equipment minutes of use ("DEM") factor. For small LECs, defined as those with fewer than 50,000 access lines, the DEM is "weighted" (i.e. multiplied by a factor) to allocate a higher percentage of local switching costs to the interstate jurisdiction. Dial equipment minutes are the minutes of holding time of the originating and terminating local dial switching equipment, and the DEM factor is expressed as a percentage relating interstate minutes of use to the total minutes of use. The DEM factor is weighted for small carriers as follows: by a factor of 3.0 for carriers with 1 to 10,000 access lines; by a factor of 2.5 for carriers with 10,001 to 20,000 access lines; and by a factor of 2.0 for carriers with 20,001 to 50,000 access lines. The maximum weighted DEM factor is 85 percent. DEM weighting provides assistance to small carriers, and is specifically provided outside of, and unrelated to, the USF assistance program. It applies to small carriers only (those with 50,000 or fewer access lines), and in theory, it recognizes that smaller telephone companies have higher local switching costs per line because they cannot take advantage of certain economies of scale. The benefitting small carriers calculate their weighted DEM as shown above, and then assign that proportion of their local switching costs to the interstate jurisdiction. Generally (but not always), the small carriers who use the weighted DEM participate in NECA pools, and therefore the additional costs are allocated to the switching rate element of NECA's traffic sensitive rate. If the carriers are not pool members, they recoup these additional costs through their own access rates. Either way, those who pay switched access charges to the LECs using weighted DEM fund the subsidy: the IXCs that pay the charges directly, and ultimately, those IXCs' customers. NECA estimated the total subsidy resultant from the DEM factor weighting to be approximately $311 million in 1995. II. History Prior to 1988, the jurisdictional separations rules provided that local switching equipment costs be split between traffic sensitive ("TS") costs and non-traffic sensitive ("NTS") costs based on an established percentage for the various types of switching equipment. TS costs (which vary with usage) were allocated between the jurisdictions by the use of a DEM factor, while NTS costs (which do not vary with usage) were allocated using the subscriber plant factor ("SPF"). Both the DEM and SPF factors were weighted to assign more costs to the interstate jurisdiction. In a 1984 Further Notice of Proposed Rulemaking, the Commission asked the Joint Board to review the jurisdictional allocation of local switching costs. As result, in 1987, the Joint Board found that changing technology and the introduction of digital switching had made it more difficult and less justifiable to divide switching costs between TS and NTS. The Joint Board therefore recommended that the TS/NTS distinction for local switching equipment be eliminated from the jurisdictional separations rules. It further recommended that all local switching costs be treated as TS, and jurisdictionally allocated based on relative usage as expressed in the measured DEM factor. This change in the allocation factors for local switching costs produced a shift of revenue requirements from interstate to intrastate. The change from using a combination of toll weighted DEM and the SPF factor to using the DEM factor alone allocated less cost to the interstate jurisdiction. To help mitigate this shift, the Joint Board recommended that the change, for all carriers, be phased in over a five-year period. It also recommended that small carriers be further assisted through the application of DEM weighting factors as described above. As stated, the Joint Board considered assistance to small carriers necessary because it thought their local switching costs were higher on a per line basis, and because it considered small carriers less able to absorb the cost shift caused by the transition to DEM. The Commission adopted the Joint Board recommended changes, and phased in the use of the DEM factor, weighted and non-weighted, during the five years 1988 through 1992. III. Competitive Effect Several mechanisms in addition to DEM weighting transfer intrastate costs to the interstate jurisdiction (and ratepayer). Although DEM weighting is a relatively small subsidy, it may create a competitive advantage for any IXC that serves areas not supported by DEM weighting. Private networks, unencumbered by this and other subsidy costs, also may have an artificial cost advantage over the contributing IXCs, especially for large customers with high interstate long-distance usage. If this causes large interstate users to divert a significant portion of their traffic to private networks, the base of subsidy contributors could be diminished. Additionally, DEM weighting (again as a part of a larger subsidy burden) may cause customers to pay higher interstate long distance rates than are justified by cost. This could disadvantage long distance calling in favor of local calling. Finally, the aggregate costs removed from the intrastate jurisdiction via the various subsidy mechanisms (including DEM weighting) may allow certain LECs to charge below-cost prices for local services. This would serve as a competitive disadvantage for potential new local market entrants. IV. Critique of DEM Weighting Like a number of other subsidies, DEM weighting causes interstate toll users to subsidize intrastate services. This has led to a number of criticisms. In particular, interstate toll users in areas served by large LECs subsidize intrastate services in areas served by small LECs, leading to distortions in both markets. Some assert that because only small LECs are eligible for the subsidy, DEM weighting adds to the "artificial" incentives created by the USF (which, as discussed in part I of "The Universal Service Fund" supra pages 50 through 52, also favors small LECs), for large LECS to sell exchanges to small LECs. Critics of DEM weighting charge that in today's technological environment, little cost differential exists between switching equipment spread over fewer lines by small carriers, and that spread over many lines by large carriers. They argue that as a result, assistance to small carriers is less necessary than it once was, because switching technology has eliminated or severely lessened cost-per-line differences. A related criticism notes that because cost differences are less significant, the DEM weighting subsidy, in reality, assists small companies, not necessarily high cost companies. The two are no longer synonymous, and therefore a continued subsidy, say the critics, based solely on size (access lines), is no longer justifiable. V. Proposals to Change or Replace DEM Weighting In the Notice of Inquiry ("NOI") concerning the USF released on August 30, 1994, the Commission invited comment regarding a proposal to include switching costs within the costs that form the basis for high-cost assistance. This would replace the current DEM weighting assistance mechanism for small carriers, and as a result, both loop and switching costs would be combined into a single form of high-cost support, presumably for all carriers. The Commission also asked for comment regarding the need to continue DEM weighting as a separate assistance program for small carriers, even if the existing USF solely on loop costs, remained unchanged. In this context, the NOI asked the very pertinent question of whether high-cost areas typically experience higher than average local switching costs as well as high loop costs. If not, the Commission asked whether DEM weighting should be eliminated or revised. After reviewing comments received in response to the NOI, on July 13, 1995, the Commission issued a Notice of Proposed Rulemaking and Notice of Inquiry. The Commission noted that commenters responding to the NOI suggested the elimination of DEM weighting, and requested comment on whether DEM weighting should be eliminated over a five year period. Comment was also invited on two alternative proposals for revising DEM assistance. The first alternative would combine switching and loop costs into a single assistance mechanism. Under the second alternative, DEM weighting would not be combined with USF assistance, but would "be targeted more narrowly in order to achieve our universal service objectives." Comment was requested on three proposed revisions to DEM weighting under the second alternative: restricting assistance to LECs with higher than average switching costs; restricting assistance to LECs using small switches; and continuing to base assistance on the number of lines served by LECs, but replacing the current threshold approach to assistance with a sliding scale. VI. Positions of Major Interest Groups Recognizing the shift of intrastate revenue requirements to the interstate jurisdiction via DEM weighting, state commissions generally favor this subsidy program. Similarly, small LECs (under 50,000 access lines) favor continuation of DEM weighting. Conversely, IXCs (and their customers), who pay for this program, oppose DEM weighting, particularly because it rewards small carriers without regard to cost. VII. Sources 47 C.F.R.  36.125. Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Proposed Rulemaking and Notice of Inquiry, 10 FCC Rcd 12,309 (1995). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Inquiry, 9 FCC Rcd 7404 (1994). MTS and WATS Market Structure; Amendments of Part 67 (New Part 36) of the Commission's Rules and Establishment of a Federal-State Joint Board, Report and Order, 2 FCC Rcd 2639 (1987). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Further Notice of Proposed Rulemaking, 49 Fed. Reg. 18,318 (1984). Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 2 FCC Rcd 2551 (Joint Bd. 1987). National Exchange Carrier Association, Transmittal No. 663, Annual 1995 Access Tariff Filing (Mar. 31, 1995). Long Term Support (LTS) I. Description The Long Term Support program reduces the pressures on IXCs to deaverage their interstate toll rates by supporting local telephone companies with higher-than-average subscriber line costs. With LTS, NECA carrier common line ("CCL") rates represent the average CCL rates of price cap LECs. LTS payments provide those high-cost LECs who are members of a NECA pool with enough support to enable them to charge IXCs only a nationwide average CCL interstate access rates (see the discussion of SLC and CCL rates infra pages 90 through 99), and yet still recover the full interstate portion of their subscriber line costs. Prior to April 1989, all LECs charged the same CCL rates, because all were required to participate in a pool of carrier common line costs and revenues. NECA aggregated the interstate portions of all LECs' subscriber line costs, calculated the per-minute CCL charge necessary to recover that amount, and all LECs charged that amount. LECs whose costs were below the average contributed revenues to the pool, and LECs whose costs were above the average received support from the pool. While the Commission permitted LECs to withdraw from the pool beginning in April 1989, it also required those LECs with below average subscriber line costs that chose to exit the pool, generally the largest LECs, to contribute enough so that LECs remaining in the pool would be able to charge the same industry average CCL rates they would have charged if the pool were still mandatory for all LECs. Following the introduction of price cap regulation, the CCL rate charged by LECs remaining in the pool is based on the average CCL rate charged by price cap LECs. The LTS program is administered by NECA. NECA begins by computing the carrier common line revenue requirement of LECs in the NECA pool (subtracting their SLC revenues from their total common line revenue requirements). NECA then calculates the average per-minute CCL charge that is charged by price cap LECs, and projects the revenues that LECs participating in the NECA pool would expect to collect by charging that average CCL rate. The difference between these amounts--the projected pool member deficit--is then provided to the pool in the form of LTS payments. LECs not participating in the NECA common line tariff fund LTS support in proportion to their share of the total number of common lines of all LECs contributing to the pool. LECs outside the pool then recover these LTS costs through their own tariffed CCL charges. LTS is considered a subsidy because LTS payments provide additional funds, which are used together with revenues from CCL charges, to cover common line costs. Because LTS ensures that IXCs do not need to pay higher CCL rates for reaching high-cost rural locations, LTS alleviates the pressure on IXCs to charge higher rates for calls to or from those locations or, by the same reasoning, to charge lower rates for calls to or from low cost locations. To the IXC industry that actually pays the subsidy (through higher access charges for LECs outside the common line pool), LTS does not represent a net subsidy, because the amount the industry pays in LTS charges is exactly offset by the amount it saves in CCL charges it would otherwise pay for serving high cost LECs. Thus, from the perspective of the IXCs, LTS is simply a mechanism for geographic averaging, leading some of the their customers to subsidize others. To the extent that some IXCs only connect relatively low cost LECs, the LTS may represent a subsidy they pay to keep CCL charges low for IXCs connecting higher cost LECs. II. History From the mid-1940s until the advent of access charges, most LECs recovered almost all of their interstate revenue requirement through a pooling process administered by AT&T known as settlements and division of revenues. This pooling process permitted LECs to achieve a uniform rate of return on their investment. It also helped AT&T justify a nationwide average toll rate schedule. When the Commission determined that the pooling process was inappropriate for the competitive environment developing in interstate services, however, it adopted the current access charge regime. Nevertheless, the Commission concluded that a common tariff and pooling arrangement covering the CCL rate element was necessary, because of the danger that LEC-specific CCL rates would generate significant pressures upon IXCs to deaverage interstate toll rates. Although the Commission prescribed mandatory pooling as a means of resolving these concerns, it recognized that pooling had some negative effects. For example, pooling limited LEC cost recovery flexibility, established economically inefficient cost/price distortions, and reduced LEC incentives to contain costs. LECs in low cost areas expressed concern that their above cost prices would encourage bypass. Moreover, LECs suffered if NECA's estimates of costs and traffic led the CCL pool to recover less than the full amount of interstate common line costs (overcharges, however, were refunded). This led a number of LECs to seek freedom from the pool. At the same time, the introduction of SLCs, the reduction of the maximum interstate allocation of common line costs to twenty-five percent, and the removal of embedded customer premises equipment from the rate base diminished the possibility of wide and significant disparities in CCL rates. The Commission eventually sought guidance about depooling from a Joint Board, and that Board, in March 1987, recommended to the Commission that mandatory pooling was unnecessary. After considering many proposals, the Joint Board rejected the proposals of Bell Atlantic and New Jersey to essentially end all pooling in the near future, and a Vermont proposal that would have required significant modifications to the Commission's separations rules. Instead, the Joint Board recommended the adoption of a plan called Unity IA, submitted in July 1986 by four industry associations: the National Rural Telephone Association ("NRTA"), the National Telephone Cooperative Association ("NTCA"), the Organization for the Protection and Advancement of Small Telephone Companies ("OPASTCO"), and the United States Telephone Association ("USTA"). That proposal created incentives for LECs to leave the pool, and all of the Bell Operating Companies ("BOCs") and GTE did. The proposal gave those who left the pool the opportunity to benefit from cuts in their common line costs. For those who were net recipients of support in the pool, the proposal also gave them transitional support that was gradually phased out over a period ending in 1994. On the other hand, the Unity 1A plan proposed LTS to protect the interests of the rural and other high cost LECs who remained in the pool. In May 1987, the Commission adopted the Joint Board's proposal. In 1990, following the introduction of price cap regulation, NECA suggested that the CCL rate charged by LECs remaining in the pool be based on the "CCL rates of exchange carriers subject to price caps, rather than prospective revenue requirements and demand." The Commission adopted that suggestion. III. Critique The LTS subsidy has been criticized as leading to the same harmful effects as the CCLC subsidy. These effects are discussed in the section of this report entitled "Recovering the 'Interstate' Portion of the Cost of Subscriber Lines: Carrier Common Line Charges (CCLCs) and Subscriber Line Charges (SLCs)." In summary, the LTS may inefficiently suppress demand. It may encourage inefficient entry in markets served by LECs forced to collect and pass on the cost of LTS, while discouraging efficient entry in markets served by LEC recipients of LTS. Finally, it has been argued that LTS does not take the economic condition of consumers into account, and so can lead to low income consumers who live in low-cost markets being charged higher rates to subsidize high income consumers who live in high-cost areas. IV. Proposals for Change by Interested Parties Some general proposals for reform have suggested that support, presumably including LTS, should be more narrowly tailored--to individual customers with financial need, who require support to remain on the network, rather than to high cost LECs based on their costs. Under the current system, high income residents who live in high-cost, low-density areas, such as Middleburg, Virginia, are indirectly subsidized by poorer urban residents. MFS draws an analogy to housing prices, and notes that individuals living in expensive urban areas are not subsidized by those in lower cost rural areas in order to keep nationwide housing costs at "reasonably equal" levels. Its argument is that all locations have advantages and disadvantages--some goods or services are relatively expensive in an area while other goods and services are relatively cheap. Consumers are generally expected to handle the tradeoffs themselves, with subsidies generally limited to those with financial need. Similarly, Teleport argues that it is not efficient to give subsidies to consumers who can afford to pay reasonable cost-based rates and would not leave the system if they were charged cost-based prices. Another proposal would continue direct support to high cost LECs, but would base the amount of support on some proxy for the characteristics of the market, such as population density or terrain that would reflect the costs to serve. Some possible proxy characteristics are listed in the Commission's August 1994 Universal Service Fund Notice of Inquiry. However, many small LECs argue that it would be impossible to create a proxy mechanism that would fairly account for the varying circumstances that small, high-cost LECs face. They warn that a proxy mechanism would lead to misallocations that could jeopardize universal service. V. Positions of Major Interest Groups Those benefiting from LTS, i.e., those living in or serving high-cost areas, including customers, state regulators, and LECs, would all likely support continuation of LTS. On the other hand, most net contributors of LTS would probably support replacement of LTS and other subsidy programs with a more targeted support program, one directing support to individuals in need rather than all entities located in high-cost areas. Yet many LECs oppose narrow targeting of benefits to individuals. On the related issue of how support should be distributed, some, like MCI, would support the creation of a system of "vouchers" that customers could use to pay for service from any provider, including a new entrant. LECs, however, respond that they need compensation for their "carrier of last resort" duties, which duties require them to invest in capacity that they may never need. Southwestern Bell argues that new entrants, which do not bear the cost of maintaining universally available network, should not receive high-cost support. Both large and small LECs contend that vouchers would raise the cost of universal service in high cost areas, would not promote competition, and would be subject to abuse. BellSouth and NTCA also argue that targeting support to individuals rather than to the incumbent LECs serving high-cost areas would create an administrative nightmare. VI. Sources 47 C.F.R.  69.105(b)(2), (3), 69.502, 69.603(e). Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Notice of Inquiry, 9 FCC Rcd 7404 (1994). Policy and Rules Concerning Rates for Dominant Carriers, Order on Reconsideration, 6 FCC Rcd 2637 (1991). Policy and Rules Concerning Rates for Dominant Carriers, Second Report and Order, 5 FCC Rcd 6786 (1990). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Report and Order, 2 FCC Rcd 2953 (1987). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 2 FCC Rcd 2324 (Joint Bd. 1987). Petition for Notice of Inquiry and En Banc Hearing of MFS Communications, RM-8388 (filed Nov. 1, 1993), responding Comments of AT&T, BellSouth, General Communications, Inc., and Southwestern Bell (filed Dec. 16, 1993), and responding Reply Comments of GTE. Comments of Colorado Pub. Serv. Comm'n, MCI, MFS, National Rural Tel. Ass'n, NTCA, Organization for the Protection and Advancement of Small Tel. Cos., Southwestern Bell, and TDS Telecom (responding to National Telecomm. & Info. Admin., U.S. Dep't of Commerce, Inquiry on Universal Service and Open Access Issues, Notice of Inquiry in Dkt. No. 940955-4255, 59 Fed. Reg. 48,112 (1994)). Teleport Comm. Group, Inc., Universal Service Assurance II: A Blueprint for Action (Nov. 1994). Rural Utilities Service Loan Subsidies fo r Telephone Service I. Description A. Loan Programs The Rural Utilities Service ("RUS") administers three loan assistance programs whose purpose is to finance the acquisition, construction and installation of telephone facilities to furnish or improve telephone service in rural areas. The three programs are: (1) two types of insured telephone loans, hardship loans and cost-of-money loans; (2) direct loans from the Rural Telephone Bank ("RTB") made at the cost of money to the RTB; and (3) RUS guarantees of market-rate loans made by the RTB or other banks. Cumulative loans under the three programs total approximately: $6.6 billion (insured telephone loans), $3.0 billion (RTB), and $0.8 billion (guarantees). 1. Rural Utilities Service Insured Loans The Rural Electrification Act of 1936, as amended ("RE Act"), authorizes the Administrator of the RUS to make insured telephone loans to telephone service providers for the purpose of furnishing and improving telephone service in rural areas. These loans are insured when purchased by a lender. There are two types of direct loans. Hardship Loans. Hardship loans are made to eligible service providers at an interest rate of five percent. Applicants must meet certain subscriber density requirements, fall within a stated range of permissible "times interest earned ratios," and participate in a state telecommunications modernization plan. Cost-of-Money Loans. Cost-of-money loans are made to eligible service providers at an interest rate equal to the current cost of money to the Government for loans of similar maturity, but not more than seven percent per year. Under Title III of the Agriculture, Rural Development, Food and Drug Administration, and Related Agencies Appropriations Act of 1996, the seven percent maximum borrower interest restriction may be exceeded for the fiscal year ending September 30, 1996. Applicants must satisfy either a subscriber density requirement (a bit more relaxed than for hardship loans) or not exceed a specified "times interest earned ratio" (also more relaxed than for hardship loans), and participate in a state telecommunications modernization plan. On request of an applicant, an application for a cost-of-money loan is also treated as an application for an RTB loan. 2. Rural Telephone Bank Loans The RTB is an agency of the United States. The Governor of the RTB (the Administrator of the RUS) is authorized to make loans to corporations and public bodies which are approved for an RUS loan or loan commitment under 7 U.S.C.  922. The loans may be made for the same purposes as RUS loans. The interest rate for RTB loans is the average cost of money to the RTB, but not less than five percent per year. On request of an applicant, an application for an RTB loan is also treated as an application for an insured cost-of-money loan. 3. Loan Guarantees The RUS Administrator is authorized to guarantee, without fee or charge, loans made by the RTB or by any other legally organized lending agency. To secure a guarantee of a non-RUS/RTB loan, the borrower must meet a specified "times interest earned ratio," but need not meet the density requirement or participate in a state modernization plan. The interest rate on such a loan is as agreed upon by the borrower and lender. Generally, as a condition of the guarantee, RUS obtains a first lien on all the assets of the borrower. The borrower may request that the loan be made by the Federal Financing Bank. B. Estimates of the Subsidy Appropriations. The Federal Credit Reform Act of 1990 ("Credit Reform Act") requires Congressional appropriations for the cost of new direct loans and new loan guarantees beginning in fiscal year 1992. The cost of direct loans, as defined by the Credit Reform Act, includes the net present value (at the time the loan is disbursed) of the loan disbursement, repayments of principal, and interest payments, adjusted for estimated defaults and prepayments. Total "subsidy" appropriations for new loans and loan guarantees issued during the last five years under the three telephone loan programs include $84.2 million (standard five percent loans during fiscal years 1992-93), $29.2 million (insured five percent hardship loans during fiscal years 1994-96), $0.2 million (insured cost-of-money loans during fiscal years 1994-96), and $12.6 million (RTB loans during fiscal years 1992-96). No "subsidy" appropriations were made for the guaranteed loan program during fiscal years 1992-96. Under the Credit Reform Act, disbursements pursuant to direct loan obligations or loan guarantee commitments made prior to October 1, 1991 do not require "subsidy" appropriations, even if disbursements continue to be made under these older loans. Other Approaches. Two other approaches have been used to estimate the size of the subsidy provided by these programs: (1) calculating the cost to the Government of raising the capital for the funds supporting the loans lent by the RTB and Rural Electrification and Telephone Revolving Fund ("RETRF") or (2) comparing the interest rates borrowers pay under the programs with the rate the Government pays to obtain the money loaned under the programs. To endow the RETRF, the U.S. Treasury made an interest-free loan of $1.9 billion in 1973. The accumulated subsidy resulting from the interest-free loan has been estimated at $3.9 billion, based on the Government's historical cost of money. Similarly, under the RE Act, Congress authorized appropriation of $30 million annually, and up to a total of $600 million, to provide capital to the RTB through the purchase of bank stock. Below market rates of return on this capital represent a subsidy. The bank pays 2 percent a year interest on this stock. This contrasts with an average cost of money to the U.S. Treasury in the 1980s of 10.3 percent. Between 1984 and 1992, the Government's cost of money has ranged from over 11 percent to 6.4 percent (in general, declining from a 1981-82 peak). During the same period, insured loans were available at 2.0 percent (hardship loans) and 5.0 percent (standard loans), and the interest rate on RTB loans ranged from the statutory minimum of 5.0 percent to 9.75 percent. The difference between the cost of money to the U.S. Treasury and the telephone company borrower is a subsidy. C. Targeting of Subsidies Rural Households and Undercapitalized Rural Telephone Companies. The customer density guidelines are designed to assure that the subsidized loans will be used to furnish or improve telephone service in rural areas. Also, the times interest earned ratio guidelines are intended to direct subsidized loans to smaller, undercapitalized, rural telephone companies and cooperatives. The targeting of loans to rural areas appears, on the whole, to have been successful. Historically, since the inception of the Rural Electrification Administration ("REA") loan program in 1949, the percentage of farm households with telephone service has risen from about thirty-five percent to ninety-six percent in 1983 and after. Penetration levels in rural southern states increased eight-fold between 1940 and 1989. Over six million subscribers are served by RUS/REA borrowers. Nevertheless, five of the eight states still below the ninety percent penetration level are considered to be poorer rural states. The targeting of under-capitalized providers seems less focused. The programs benefit "several large non-Bell telephone holding companies and smaller telephone companies and cooperatives that are on sound financial footing." Generally, the net income of telephone borrowers has risen dramatically since the late 1980s. Statewide Modernization as a Mechanism for Targeting Rural Areas. The Rural Electrification Loan Restructuring Act of 1993 ("RELRA") requires that a telecommunications modernization plan be established in a state before any telephone borrowers within the state can be eligible for hardship or concurrent REA cost-of-money and RTB loans. RELRA requires that state plans provide for, among other things, elimination of party line service, availability of telecommunications services for improved business, educational and medical services, uniform deployment of advanced services in rural and non- rural areas, and, in particular, conference calling, video images and data at a rate of at least one million bits of information per second (1 Mbps). In this manner, Congress sought to retarget the REA/RUS loan subsidies to promote inclusion of rural areas in the developing "information superhighway." REA issued interim regulations in December 1993 to implement RELRA requirements. State PUCs were given one year from the effective date of the interim rule to develop such a plan. REA's regulations, and its interpretation of RELRA requirements, however, provoked a storm of comments from state commissions, telephone companies and others. Principal concerns were the preemptive effect of the rules, inclusion of specific transmission and capacity requirements, and overly aggressive timetables. In response to these comments, RUS published proposed amendments. The amendments became effective March 15, 1995. The technical and timeframe requirements were relaxed. State PUCs had until February 13, 1996 to prepare and submit a state plan. If no state plan was submitted by that date, a majority of borrowers within a state may submit a plan. RUS and RTB telephone loans will only be available after February 16, 1996 to a borrower who is participating in an approved State Telecommunications Modernization Plan. Also, RUS has grouped the statutory requirements into "short-term" and "medium-term" requirements, which specify upgraded service standards effective one year after plan approval and six years after plan approval, respectively. RUS loan guarantees will continue to be available, even in the absence of a state plan. II. Competitive Effect of the Subsidy In theory, the costs of insured loans and RTB loans borne by the Government, rather than the rural telephone company or cooperative, make marginal investment in new or improved rural telephone service economically viable. That is, the subsidies are thought to be necessary for providers to enter or stay in the rural telephone market. A second or new provider entering the same market must find a way to level the playing field. Where there is already a subsidized carrier, the new entrant must not only deal with the high costs of providing service, but the ability of the existing carrier to charge prices below the true cost of service, made possible by the subsidy. Thus, the effect of the subsidy is to raise the already high barrier to market entry. In the event that a second carrier attempts to enter the same rural market, it may be because either (1) the original premise for the subsidy, i.e., that the investment was not economically viable without the subsidy, is no longer true, or (2) the new entrant believes that it also can obtain a subsidy. It appears that the presence of the subsidies is affecting the organization of the telephone industry. Reportedly, US West is selling rural exchanges to independent telephone companies, on the stated theory that small companies can serve rural areas better and have advantages that US West does not have, such as receipt of REA/RUS loans and high-cost assistance. III. Critique of the Subsidies A recent review of loan subsidies to rural telephone companies implies that the primary original objective of the REA programs--providing telephone service to farm households--has largely been met for over a decade. Penetration of telephone service on farms increased from about thirty-five percent at the inception of the REA program in 1949, to about ninety-five percent in 1980; since then, penetration has remained more or less constant. In 1983, the 96 percent telephone penetration level for farms exceeded that of the population, generally. One critic explains that because all customers in high cost rural areas receive the benefit of the loan subsidy without regard to whether the subsidy is necessary for them to obtain or afford telephone service, the subsidy is inefficient in terms of cost causation pricing. Some argue that the recipients of Government-subsidized telephone loans are increasingly financially sound. The net income of telephone borrowers and other measures of financial security have greatly increased over the last decade. Originally intended to aid small undercapitalized rural telephone companies or cooperatives, current recipients include large telephone holding companies, as well as profitable small companies. For example, subsidiaries of Telephone and Data Systems ("TDS") received ten loans in fiscal year 1993, totalling $32.7 million; by the end of 1992, REA/RUS, RTB and Federal Financing Bank ("FFB") mortgage notes accounted for $225 million of the $405 million in long term debt of the parent company. Other 1993 loan recipients were subsidiaries of Pacific Telecom, Rochester, and Century. One smaller company, Guadalupe Valley Telephone Cooperative, Inc., of Texas, with outstanding REA/RUS debt of $5.4 million, was "forced" to invest almost $7 million in tax-exempt securities and over $3 million in non-interest bearing accounts to preserve its tax-exempt status with the Internal Revenue Service. IV. Sources Agriculture, Rural Development, Food and Drug Administration, and Related Agencies Appropriations Act of 1996, Pub. L. No. 104-37, 109 Stat. 299 (1995). Rural Electrification Act of 1936, 7 U.S.C.  901-950b (1994). Federal Crop Insurance Reform and Department of Agriculture Reorganization Act of 1994, Pub. L. No. 103-354, 108 Stat. 3178 (1994). Rural Electrification Loan Restructuring Act of 1993, Pub. L. No. 103-129, 107 Stat. 1356 (1993). Federal Credit Reform Act of 1990, Pub. L. No. 101-508, Title XIII, sec. 13201(a), 104 Stat. 1388 (1990) (codified at 2 U.S.C.  621 note, 661, 661a-661f (1994)). 7 C.F.R.  1735.32, 1751.102, 1751.106, 1610.10. Rural Electrification Admin., U.S. Dep't of Agric., Telecommunications System Planning and Design Criteria, and Procedures, Proposed Rule, 59 Fed. Reg. 53,939 (1994) (amending part of the December 1993 interim regulations implementing RELRA, 7 C.F.R.  1751, and discussing comments received in response to those interim regulations). Rural Tel. Bank, U.S. Dep't of Agric., Determination of the 1995 Fiscal Year Interest Rates on Rural Telephone Bank Loans, Notice, 60 Fed. Reg. 56,561 (1995). Rural Tel. Bank, U.S. Dep't of Agric., Determination of the 1994 Fiscal Year Interest Rates on Rural Telephone Bank Loans, Notice, 59 Fed. Reg. 55,251 (1994). Rural Utils. Serv., U.S. Dep't of Agric., Telecommunications System Planning and Design Criteria, and Procedures, Final Rule, 60 Fed. Reg. 8,171 (1995). Comments of Pennsylvania Pub. Util. Comm'n, to the Interim Rule with Request for Comments (Feb. 18, 1994) (responding to Rural Electrification Admin., U.S. Dep't of Agric., Rural Telephone Bank and Telephone Program Loan Policies, Procedures, and Requirements; Telecommunications System Planning and Design Criteria, and Procedures and Construction Policies and Procedures; and Telecommunications Standards and Specifications for Materials, Equipment and Construction, Interim Rule with Request for Comments, 58 Fed. Reg. 66,250 (1993) (issuing December 1993 interim regulations implementing RELRA requirements)). RURAL ELECTRIFICATION ADMIN., U.S. DEP'T OF AGRIC., INFORMATIONAL PUBLICATION 100-7, REPORT OF THE ADMINISTRATOR, FISCAL YEAR 1993 (1994). Joseph P. Fuhr, Jr., Telephone Subsidization of Rural Areas in the USA, 14 TELECOMM. POL'Y 183 (1990). The Independents: Federal Regulation, INSIDE TELECOM (Mar. 1, 1994). Telcos Oppose Hollings Legislation to Ease MFJ Curbs, COMMON CARRIER WK., May 9, 1994. J. Cale Case & Mark G. Ciolek, Federal Telecommunications Subsidies in the USA (Apr. 1993) (available from Palmer Bellevue Corp., 111 W. Washington St., Suite 1247, Chicago, IL 60602). Douglas A. Dawson, et al., Keeping Rural America Connected: The Dynamics of Serving Rural America (available from OPASTCO, 21 Dupont Circle N.W., Suite 700, Washington, DC 2036). Telephone Interview with Linda M. Buckley, Editor and Publications Manager, Organization for the Protection and Advancement of Small Telephone Companies (Jan. 1996). Telephone Interviews with Jon Claffey, Financial Analyst, Rural Utilities Service, U.S. Department of Agriculture (Feb. 1996). V. Background Sources 7 C.F.R.  1610. Rural Electrification Admin., U.S. Dep't of Agric., Rural Telephone Bank and Telephone Program Loan Policies, Procedures, and Requirements; Telecommunications System Planning and Design Criteria, and Procedures and Construction Policies and Procedures; and Telecommunications Standards and Specifications for Materials, Equipment and Construction, Interim Rule with Request for Comments, 58 Fed. Reg. 66,250 (1993). Comments of Pennsylvania Pub. Util. Comm'n, to the Proposed Rule (November 28, 1994) (responding to Rural Electrification Admin., U.S. Dep't of Agric., Telecommunications System Planning and Design Criteria, and Procedures, Proposed Rule, 59 Fed. Reg. 53,939 (1994)). RURAL ELECTRIFICATION ADMIN., U.S. DEP'T OF AGRIC., INFORMATIONAL PUBLICATION 100-1, RURAL ELECTRIFICATION ACT OF 1936, WITH AMENDMENTS AS APPROVED THROUGH DECEMBER 17, 1993 (1994). RURAL ELECTRIFICATION ADMIN., U.S. DEP'T OF AGRIC., INFORMATIONAL PUBLICATION 100-7, A BRIEF HISTORY OF THE RURAL ELECTRIC AND TELEPHONE PROGRAMS, AND REPORT OF THE ADMINISTRATOR, FISCAL YEAR 1992 (1993). Recovering the "Interstate" Portion of the Cost of Subscriber Lines: Carrier Common Line Charges (CCLCs) and Subscriber Line Charges (SLCs) I. Overview Local telephone companies collect carrier common line charges ("CCLCs") and subscriber line charges ("SLCs") (also known as end user common line charges) to cover the portion of the cost of subscriber lines allocated to the interstate jurisdiction. Subscriber lines are the transmission paths connecting switched access customers to LEC switching centers at end offices. Under current Commission rules, LECs recover 25 percent of the cost of these switched subscriber lines, which are also called common lines or loops, from interstate services primarily through CCLCs and SLCs. SLCs are flat rate monthly charges assessed to end user customers; CCLCs are per minute charges assessed to IXCs. LECs recover the remaining 75 percent of their switched subscriber line costs (less any common line costs assigned to the interstate jurisdiction through the universal service fund) from end users through charges for local and other intrastate services. After LECs have calculated their interstate subscriber line costs, they are required to recover as much of them as they can through monthly SLC rates of up to $3.50 per line for residential and single line business customers and $6.00 per line for multi-line business customers. Any of their subscriber line costs that remain unrecovered from SLCs are recovered, together with a few nonsubscriber line items--such as long term support-- through per-minute CCL charges. LECs subject to rate of return regulation divide their CCL revenue requirement by their projected minutes of traffic to compute their CCL rates. LECs subject to price cap rules set their CCL rates based on an adjusted rate from their previous year. If the CCLC comes to less than $.01 per minute, the rate is the same for both originating (outgoing) and terminating (incoming) traffic. If, however, the average rate would be more than $.01 per minute, then the CCLC for originating traffic is set at $.01 per minute and the remaining interstate portion of the subscriber line costs are recovered through a higher terminating traffic charge. For example, in 1993, GTE had an originating CCL rate of $.01 per minute and a terminating rate of more than $.0236 per minute, while Pacific Bell's rate of $.0042 per minute was the same for traffic in both directions. Services that use common line facilities at only one end, such as 800 and WATS, are assessed the higher terminating charge. The SLC is sometimes characterized as a subsidy to residential subscribers, because the rules impose a higher SLC on business customers than on residential customers. Moreover, business lines may actually be less costly than residential lines, because they are likely to be installed in higher density areas, and in large quantities, leading to lower per-line installation costs. On the other hand, since a business line customer's SLC generally does not recover even the interstate portion of the cost to the LEC of providing that subscriber line, with the rest being recovered through CCL charges, one might also conclude that the business SLC not only does not generate a subsidy, but requires a subsidy, albeit, reduced, to cover the interstate allocation of that line's costs. CCLC payments represent subsidies to the degree that high-usage customers pay more through interstate SLC and CCL charges than the interstate portion of their subscriber line costs, while low-usage customers pay less than the interstate portion of the cost of those lines. Thus, to the extent this occurs, the current system causes customers with high traffic levels to subsidize those with low traffic levels. Furthermore, to the degree that the Commission's rules keep originating CCL rates below terminating rates (which was done to discourage bypass) they create an uneconomic pricing distortion. II. Background Prior to 1943, AT&T recovered all of its subscriber line costs through charges for local service. AT&T used a "board-to-board" system, whereby toll calls were set to recover only those costs incurred to transmit calls from the originating toll board to the terminating toll board. None of the costs of the local exchange were recovered from toll calls. Beginning in 1943, AT&T separated its local exchange costs, allocating a portion to be recovered from interstate services. This separation of local exchange costs into interstate and intrastate portions was mandated, in 1947, when the Commission adopted a Separations Manual. That manual, developed jointly by the Commission and the National Association of Regulatory Utility Commissioners ("NARUC"), was revised many times to shift greater and greater portions of local plant costs to the federal jurisdiction until 1981 when the allocation increases were halted and reversed. At that point, the separations formula assigned 28 percent of non-traffic sensitive local exchange costs for recovery from interstate services, even though interstate traffic represented less than 9 percent of local subscriber line usage. AT&T was willing to shift costs this way, because the shift increased its interstate costs at a time when its toll call costs were declining and the Commission was threatening to impose rate reductions. State regulators supported the shift because it diminished the costs that needed to be recovered from basic local rates. The Commission approved the shift, because it accepted the argument that keeping basic local rates low was the best way to make telephone service more affordable to consumers and thus to increase nationwide telephone penetration. Prior to its divestiture, AT&T collected its interstate revenues through per-minute long distance charges to callers, except for those revenues collected for WATS and private line service. Each month, AT&T divided interstate revenues with its Bell operating company affiliates and the independent telephone companies through processes known as division of revenues and settlements, respectively. Under these procedures, each company recovered its interstate costs as determined by a set of separations procedures, as well as a return on its investment. To adjust for the consequences of divestiture, the Commission adopted an access charge regime under which interstate subscriber line costs were recovered through CCL and SLC rates. The first CCL rate (in 1984) was $.0524 per minute, which IXCs paid to both the originating and the terminating LECs on a call for a total CCL charge of more than $.10 per minute. CCL rates fell quickly, however, with the introduction of residential SLCs. LEC investments in CPE and inside wiring gradually disappeared from the interstate rate base that was recovered through SLCs and CCLCs, and a 25 percent maximum allocation of interstate costs also cut the interstate share of costs that were recovered through the CCLC. Since the costs of providing subscriber lines to customers are not sensitive to the number of minutes they are used, the Commission initially proposed to recover them through a flat monthly fee. It suggested a SLC of $6 per month (equivalent to more than $10 per month in 1995 dollars). This proposal met strong opposition, because it was viewed by many as significantly raising the minimum price of basic monthly service for those who made few long distance calls and who had become accustomed to the preexisting subsidized local rates. Opponents of a SLC argued that such a charge would price telephone service beyond the budgets of a significant portion of telephone subscribers, and thus diminish overall levels of telephone penetration. In response to this opposition, the Commission referred the matter to a Federal-State Joint Board. The Commission then issued two orders adopting the Joint Board recommendations, instituting a SLC charge and gradually increasing the portion of the non- traffic-sensitive ("NTS") interstate common line costs recovered through the SLCs. The monthly residential SLC was phased in over five steps: from $1.00, beginning June 1985, to $3.50, beginning April 1989. It has remained at the $3.50 level. Despite the concerns of SLC opponents, not only did the resulting lower per-minute prices for interstate calls lead to more affordable long distance rates for all consumers, and thus a significant increase in interstate traffic, but overall telephone penetration levels did not decline. In fact, subscribership levels actually increased, although that may be at least partially due to the Lifeline and Link Up programs, discussed in the "Lifeline and Link Up" section of this report, supra pages 34 through 44. III. Critique One of the primary alleged harms of the CCLC has been the diminished demand for toll service caused by the higher per-minute prices produced by CCL charges. While the CCLCs may have fostered universal service by keeping the total monthly charge lower than it would otherwise have been, some contend that more efficient means for promoting universal service are available and that CCLC subsidies produce harmful effects. MCI and others argue that the CCLC has created major market distortions; they contend that it would be more appropriate to subsidize basic residential access through an assessment on the net revenues of all common carriers. Sprint and AT&T warn that maintaining subsidy-laden access charges would pose competitive problems once the Regional Bell Operating Companies ("RBOCs") are permitted to offer long distance service between local access and transport areas ("interLATAs"). A LEC, with a large geographically contiguous service area, may be able to use its subsidized local exchange network to complete long distance calls, without paying inflated access charges, thus undercutting the IXCs. Some contend that increased CCLC rates hamper the development of competitive telecommunications markets, that could increase universal service by producing lower prices. For example, unnecessarily high CCLC rates may prevent incumbent LECs from retaining their public network customers with the highest levels of interstate traffic. This could occur where competitors are able to undercut LEC prices, even though the new entrants' costs are higher than the LECs' economic costs. The situation could arise because customers who generate high levels of interstate traffic, particularly multi-line business customers, incur significantly greater CCLC and SLC charges than the actual cost of the interstate portion of their common lines. This permits otherwise similarly situated competitors to serve high traffic customers by charging a cost-based rate lower than the corresponding LEC rates. Where the competitor's costs and prices are lower than the price produced by the LEC's package of SLC, CCLC, and other charges, the competitor would be able to offer customers a financially attractive alternative to the LEC. LECs have responded to this threat by offering more cost-based prices to their highest volume customers for dedicated lines from the customers' premises to IXC points of presence. CCLC subsidies, some argue, may distort competition for those LEC customers with the lowest volume of interstate traffic. Because these customers generate such low levels of interstate traffic, they do not contribute enough in CCL charges to cover the actual interstate share of their loop costs. Therefore, these customers are likely to be unprofitable for the LEC to serve at existing rates, absent subsidies. Even new entrants using technologies that bring their costs below those of the incumbent LEC may not be able to match the subsidized prices charged by the LEC. This inhibits new entrants from competing to serve customers in these markets. Critics also argue that SLC and CCLC subsidies have the ironic consequence of causing low income individuals who make many interstate calls to subsidize wealthy individuals who do relatively little interstate calling. This arises because the subsidies generated and distributed by the SLC and CCLC are collected and distributed without regard to a customer's income or wealth. IV. Proposals for Change by Interested Parties AT&T and GTE, among others, have advocated that the entire amount of dedicated common line costs should be recovered on an NTS basis, via a SLC. MCI has proposed that CCLC and two other support charges be replaced with a new, single universal service mechanism that would be funded by all telecommunications participants on a competitively neutral basis. It has been argued that the SLC has not been adjusted to even account for inflation since 1989. Making such an adjustment would require an increase in the maximum residential SLC to at least $4.50 and the multi-line business SLC to at least $8 per line per month. LECs facing new or prospective competition in markets where the SLC and CCLC now lead them to overcharge certain segments of their customer bases also support a more cost-based approach. Most of these carriers favor what they call "rate rebalancing" or "pricing flexibility." Both of these approaches would permit the carriers to cut their rates in competitive markets while increasing their rates in non-competitive markets. Although these proposals are not inconsistent with a shift to recovery of dedicated costs on an NTS basis, these options would give carriers much greater discretion and ability to exercise their market power. Critics argue that these proposals would allow LECs to set prices below cost in competitive markets, and compensate with excessive monopoly prices in non-competitive markets. Finally, LECs have proposed that they be allowed to recover CCL charges by bulk billing IXCs directly, based on each IXC's total monthly minutes of use ("MOU"). Under bulk billing, a LEC would bill each IXC for CCL costs in proportion to the IXC's nationwide percentage of MOU, rather than assessing a CCLC per minute. This would eliminate the opportunity for a LEC competitor to attract an IXC by charging a lower access charge price than the LEC. The IXC would still be required to contribute the same portion of the LEC's CCL charges as it would otherwise have contributed. While deterring such entry would be good public policy when the potential competitor had higher costs than the incumbent LEC, such bulk billing would also deter new entrants who were more efficient than the LEC. One IXC commenter complained that bulk-billing would be anticompetitive because it would permit an incumbent LEC to receive the same subsidy regardless of its customers' total IXC toll minutes. This commenter argues that the LEC would have no incentive to lower access charges to encourage toll calls, but could continue to charge artificially low subsidized local exchange rates to thwart local competition. Bulk-billing would also undermine the principle, advocated by the IXCs, that universal service subsidies should follow the customers, not go solely to incumbent LECs. V. Positions of Major Interest Groups Large industry groups, including the largest telecommunications users, would probably favor the replacement of the CCLC with higher SLCs. Strong opposition to this would probably come from the same groups who opposed the initial Commission proposal to set high SLCs, including consumer groups, some state commissions (who would hear complaints from consumers), and some members of Congress. These groups might argue that increased SLCs would make telephone service unaffordable to many infrequent users of interstate service and thus diminish penetration--even though their prior fears proved unfounded. LECs serving a large portion of low income customers who make relatively few interstate calls might also fear the loss of customers, although they might be more supportive if they were confident that the Lifeline and Link Up programs would be sufficiently funded to protect against decreases in telephone penetration. VI. Sources Smith v. Illinois Bell Tel. Co., 283 U.S. 133 (1930). United States v. Western Elec. Co., 569 F. Supp. 990 (D.D.C. 1983). 47 C.F.R.  61.42(d)(1), 61.45(c), (d)(1)(iv). 47 C.F.R.  69.104, 69.105, 69.115, 69.203(a), 69.501-.502. MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Report and Order, 2 FCC Rcd 2953 (1987). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Decision and Order, 50 Fed. Reg. 939 (1985), 57 Rad. Reg. 2d (P & F) 511 (1984). MTS and WATS Market Structure; Amendment of Part 67 of the Commission's Rules, Further Notice of Proposed Rulemaking, 49 Fed. Reg. 18,318 (1984). Reply Comments of Ameritech, to the Petition for Declaratory Ruling and Related Waivers, attachment G (filed July 12, 1993) (responding to Ameritech, Petition for Declaratory Ruling and Related Waivers to Establish a New Regulatory Model for the Ameritech Region (filed Mar. 1, 1993) (summarized in Pleading Cycle Established for Comments on Ameritech's Petition for Declaratory Ruling and Related Waivers to Establish a New Regulatory Model for the Ameritech Region, Public Notice, 8 FCC Rcd 2964 (1993))), cited in National Telecomm. & Info. Admin., U.S. Dep't of Commerce, Inquiry on Universal Service and Open Access Issues, Notice of Inquiry in Dkt. No. 940955-4255, 59 Fed. Reg. 48,112, para. 51 & n.72 (1994). Comments of AT&T, GTE, and Southwestern Bell to the Petition for Waiver (Sept. 12, 1994) (responding to Rochester Tel. Corp., Petition for Waivers to Implement Open Market Plan (filed July 29, 1994) (summarized in Pleading Cycle Established for Comments on Rochester's Petition for Waivers of Part 69 of the Commission's Rules Related to Access Charges, Public Notice, 9 FCC Rcd 4036 (1994))). Comments of AT&T, MCI, and Sprint (responding to National Telecomm. & Info. Admin., U.S. Dep't of Commerce, Inquiry on Universal Service and Open Access Issues, Notice of Inquiry in Dkt. No. 940955-4255, 59 Fed. Reg. 48,112 (1994)). FEDERAL-STATE JOINT BOARD STAFF IN CC DKT. NO. 80-286, MONITORING REPORT MAY 1995 CC DKT. NO. 87-339 (1995). Comments of GTE, to the Petition for Waiver (Nov. 15, 1994) (responding to NYNEX, Petition for Waiver of Part 69 Rules (filed Oct. 3, 1994) (summarized in Pleading Cycle Established for Comments on NYNEX's Petition for Waiver of Commission's Rules to Establish Unbundled Common Lines, Public Notice, 9 FCC Rcd 6070 (1994))). RICHARD GABEL, DEVELOPMENT OF SEPARATIONS PRINCIPLES IN THE TELEPHONE INDUSTRY 128 (1967). MICHAEL K. KELLOGG ET AL., FEDERAL TELECOMMUNICATIONS LAW (1992). Mark S. Fowler et al., "Back to the Future": A Model for Telecommunications, 38 FED. COMM. L.J. 145 (1986). Alfred E. Kahn & William B. Shew, Current Issues in Telecommunications Regulation: Pricing, 4 YALE J. ON REG. 191 (1987). Eli M. Noam, Federal and State Roles in Telecommunications: The Effects of Deregulation, 36 VAND. L. REV. 949 (1983). John D. Borrows et al., National Regulatory Research Inst., NRRI 94-08, Universal Service in the United States: Dimensions of the Debate (June 1994) (available from National Regulatory Research Institute, 1080 Carmack Rd., Columbus, OH 43210). Study Area Access Rate-Averaging I. Description Under the current access charge structure, LECs are generally required to offer interstate access services at averaged rates throughout a study area. A study area is generally the area within a single state served by a particular LEC. Rate averaging generally is justified as furthering the purpose articulated in the Communications Act of 1934: to assure nationwide communications services at reasonable rates to all the people of the United States. Under the access rate averaging policy, interstate access rates usually do not reflect the differences between the unit cost of providing service in high-density and low-density service areas. In addition, interstate access rates generally do not reflect differences in the cost of the technology used by the LEC to provide the underlying facilities for a particular service. Finally, for some services (such as common line service), rate averaging means that distance--the length of the transmission path--is not a factor in the pricing of the service. Rate averaging is often regarded as a subsidy mechanism because it averages cost differences in providing service to customers so that individual ratepayers that impose higher than average costs on the carrier do not pay that full cost. Other ratepayers, however, pay more than they would pay if their actual costs were reflected in individualized prices. Rate averaging enables a provider to avoid the administrative costs of implementing a system of individualized, cost-based rates. The beneficiaries of rate averaging tend to be those customers in low density locations or those located further from a telephone company end office, as in rural or outlying suburban areas. Customers located closer to an end office--who are often less costly to serve--pay the same rates as those customers located further from the end office, even though the latter customers cost more to serve. Since LEC end offices are generally located in business districts, this also probably means that business customers, as a class, are supporting the lower rates for residential customers, as a class. Finally, because urban areas permit carriers to carry traffic over facilities that operate at higher speeds--with lower unit costs-- than are cost-justified for rural areas, rates paid by urban customers generally support lower rates for rural customers. A. Exceptions to the Study Area Access Rate Averaging Requirement The Commission has permitted two forms of pricing that are exceptions to the study area-wide rate averaging requirement. 1. Traffic Density Related Rate Zones The first pricing option permits LECs to price their special access and switched transport services at different levels in different zones within a study area. This policy was adopted in the expanded interconnection proceeding. In that proceeding, the Commission reduced barriers to competitive entry into the exchange access market by requiring LECs to interconnect their facilities with the transmission facilities of third parties at LEC end offices, and certain other designated points, for the provision of special access and switched transport services. This interconnection permits interconnectors to use part of a LEC access network to originate or terminate an interstate special access or switched transport transmission. The LEC-provided cable that joins the LEC facilities to the interconnectors' facilities is referred to as a "cross-connect." Once a LEC is providing a special access or switched transport cross-connect in a given study area, it is permitted to deaverage its special access or switched transport rates, respectively, in that study area. This pricing flexibility permits a LEC to respond to competition when it is actually present in the study area, but not before it exists. The deaveraging is accomplished through the establishment of density pricing zones that group offices in accordance with traffic density-related factors, as well as other relevant factors (e.g., contiguity to a higher density zone). The LECs that established density pricing zones all used a three-zone structure. Assigned to zone 1 are those exchange carrier end offices in areas with the highest traffic densities, and thus relatively low per unit costs. Zone 3 includes end offices with the lowest traffic densities, and thus relatively high per unit costs. The amount rates may diverge in different zones is controlled by a series of banding factors to avoid sudden shifts in the effective prices assessed on customers. 2. Volume Discounts The second switched transport pricing option is the ability of a LEC to offer volume discounts. A LEC may offer volume and term discounts that are cost-supported under the Commission's new services test for price cap LECs if there is sufficient evidence that actual competition exists based on the number of switched transport cross-connects that have been provided to interconnectors. These volume discounts may be incorporated into the zone density pricing system. B. Funding The rate averaging process itself provides the vehicle for financing these subsidies to the extent that they exist. The cost of rate averaging is difficult to measure since it is not explicitly identified in a separate charge. That cost, however, may be significant. II. History Prior to divestiture, AT&T provided interstate message telecommunications service at nationally averaged, distance-sensitive rates. In adopting the access charge rules, the Commission required the LECs to average their rates on a study area basis. This determination was premised on the conclusion that the LECs did not possess the data necessary to cost-support deaveraged rates. As the Commission focused its attention on reducing barriers to competitive entry into the interstate exchange access market, it recognized that, in the long term, rate averaging would not be sustainable, nor would it necessarily maximize consumer welfare. Accordingly, in the expanded interconnection proceeding, the Commission began the process of deaveraging rates in a phased manner through the density zone pricing and volume discount policies discussed above. LECs have always been able to offer volume discounts for special access services. III. Critique Most of the criticisms of rate averaging focus on the possible misallocation of economic resources it causes when competition is introduced in particular segments of the local exchange market. These arguments are summarized below. Rate Averaging May Encourage Uneconomic Market Entry. The requirement that LECs average their interstate access rates may significantly effect the development of competition in the interstate exchange access market. First, averaged rates encourage competitors to enter in areas in which rates are higher than their underlying costs, even if the entrant may not be the most efficient provider. A new entrant will be attracted to markets in which its costs are below the price charged by the incumbent LEC, although not necessarily below the incumbent LEC's cost. Under study-area wide averaged pricing, a LEC must lower its access rates throughout the entire study area if it is to respond to the competition. Thus, the LEC may be required to forego revenues in high-cost areas it serves, even though its rates may already be below cost, or contribute less to the LEC's overheads than do the rates in lower cost areas. Once an entrant has entered the market, regulators may be reluctant to approve more economic pricing policies for LECs if those policies might eliminate the new entrant from the market, even though the new entrant may not be the lowest cost provider of the services in question. If such a scenario were to develop, the total cost of the services in question would be greater than it otherwise would be. Rate Averaging May Deter Competitive Entry in High-Cost Areas. The corollary to the previous paragraph is that competitive entry in high cost areas is deterred because the LEC's prices in those areas are below the LEC's real costs of providing service. Thus, a firm is precluded from entering a market unless the new entrant can price below the LEC's relatively low price. This could preclude entry, even though the new entrant would be a more efficient provider than the LEC. Without a credible threat of competitive entry, the LEC lacks incentives to become more efficient. Rate Averaging May Erode the Base of LEC Customers to Absorb the Costs of the Switched Access Network. The maintenance of artificially high rates in low-cost areas also affects the behavior of larger business customers who often are located in areas that could be lower cost areas. These large customers have the incentive and the resources to pursue alternatives to LEC-provided switched access service. Thus, they are likely to use a LEC's special access service, as well as services of competitive suppliers. In either case, the number of customers using the LEC's switched access network is reduced and fewer customers are left to pay the subsidies inherent in the averaged switched access rates. This may raise the costs for the remainder of the LEC's switched access customers generally, and allegedly may, over time, lead to a reduction in the service quality afforded through the LEC switched access network. IV. Proposals by Interested Parties for Changing the Subsidy The LECs have proposed a variety of methods to address the problems they perceive to exist with study area wide rate averaging. These proposals follow either of two models: (1) additional pricing flexibility for LECs generally; or (2) identifying some of the costs as subsidy amounts and bulk billing those sums to IXCs based on an allocator derived from a market share indicator. The United States Telephone Association ("USTA") has proposed that LECs be regulated through a structure that applies differing levels of regulation to the LECs as they move from markets that are not competitive (initial market areas), to markets in which some competition exists (transitional market areas), to areas that are fully competitive (competitive market areas). As part of this plan, USTA proposes that any subsidies be explicitly identified and included in a public policy element that would be assessed upon IXCs in a competitively neutral manner. Some LECs have proposed extending the density zone pricing concept developed for the special access and switched transport services to other access services. V. Positions of Major Interest Groups Large LECs. The larger LECs, who face the prospect of more competitive pressures, support granting LECs more pricing flexibility in the face of increased competitive entry in the interstate exchange access markets. They argue that this is necessary as a matter of fairness and contend that absent increased pricing flexibility, there will be an adverse effect on their ability to continue providing the subsidies that are implicit in rates developed using rate averaging principles. Smaller LECs. Smaller LECs, often serving rural areas, are less disposed to support deaveraging of interstate access rates, presumably because of the potential for IXCs to deaverage interstate toll rates, which would increase the toll rates their subscribers pay. Competitive access providers. Competitive access providers, on the other hand, argue that price cap LECs have sufficient flexibility under the existing price cap rules, and that the LECs should not be given more pricing flexibility until they demonstrate that effective competition exists in the exchange access market. IXCs. AT&T has opposed any deaveraging of LEC access rates that is not cost- based. Comptel, representing the smaller IXCs, supports deaveraging of LEC access rates, presumably because its members do not serve high-cost areas to the same extent that AT&T does. Users. Large business interests, which are often located in low-cost areas, support giving the LECs more pricing flexibility because they perceive that it will redound to their benefit in the form of lower rates. Low-volume users generally oppose deaveraged rates because of the perception that it would result in increased rates for them. VI. Sources 47 U.S.C.  151. 47 C.F.R.  69.3(e)(7). Expanded Interconnection with Local Telephone Company Facilities, Memorandum Opinion and Order, 9 FCC Rcd 5154 (1994). Expanded Interconnection with Local Telephone Company Facilities, Third Report and Order, 9 FCC Rcd 2718 (1994). Expanded Interconnection with Local Telephone Company Facilities; Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Second Report and Order and Third Notice of Proposed Rulemaking, 8 FCC Rcd 7374, further recon., Expanded Interconnection with Local Telephone Company Facilities, Second Memorandum Opinion and Order on Reconsideration, 8 FCC Rcd 7341 (1993). Expanded Interconnection with Local Telephone Company Facilities; Amendment of the Part 69 Allocation of General Support Facility Costs, Report and Order and Notice of Proposed Rulemaking, 7 FCC Rcd 7369, recon., Memorandum Opinion and Order, 8 FCC Rcd 127 (1992), vacated in part and remanded sub nom. Bell Atlantic Tel. Cos. v. FCC, 24 F.3d 1441 (D.C. Cir. 1994). MTS and WATS Market Structure, Third Report and Order, 93 FCC 2d 241, modified on recon., Memorandum Opinion and Order, 97 FCC 2d 682 (1983), modified on further recon., Memorandum Opinion and Order, 97 FCC 2d 834, aff'd in principal part and remanded in part sub nom. National Ass'n of Regulatory Util. Comm'rs v. FCC, 737 F.2d 1095 (D.C. Cir. 1984), cert. denied, 469 U.S. 1227 (1985). Customers First: Ameritech's Advanced Universal Access Plan, Petition for Declaratory Ruling and Related Waivers of Ameritech (filed Mar. 1, 1993) (summarized in Pleading Cycle Established for Comments on Ameritech's Petition for Declaratory Ruling and Related Waivers to Establish a New Regulatory Model for the Ameritech Region, Public Notice, 8 FCC Rcd 2964 (1993)). Petition for Waiver of the NYNEX Tel. Cos. (Dec. 13, 1993). Rochester Tel. Corp., Petition for Waivers to Implement Open Market Plan (filed July 29, 1994) (summarized in Pleading Cycle Established for Comments on Rochester's Petition for Waivers of Part 69 of the Commission's Rules Related to Access Charges, Public Notice, 9 FCC Rcd 4036 (1994)), and responding Comments of GTE and Southwestern Bell (Sept. 12, 1994). Reform of the Interstate Access Charge Rules, Petition for Rule Making of the United States Telephone Association, RM-8356 (filed Sept. 17, 1993). Non-Traffic-Sensitive Switching Costs I. Description The Commission's separations and access charge rules treat the costs of local switching as being traffic sensitive in character. The interstate local switching access category includes a variety of equipment performing different functions, including, inter alia, the actual switching of calls, the termination of calls at the switch, and the recording of call data. The termination of calls at the switch could relate either to the line-side termination of local loops, or to the trunk-side termination of interoffice trunks. In 1987, at the time the decision was made that separations rules would no longer distinguish between non-traffic-sensitive ("NTS") and traffic-sensitive local switching costs, several LECs argued before the Joint Board and the Commission that such a distinction in fact existed. More recently, NYNEX has argued for an alternative recovery mechanism for alleged NTS local switching costs associated with line-side loop terminations. The Commission refused to consider this claim in a waiver context. NYNEX noted that the New York Public Service Commission had established a separate port charge to recover the comparable costs at the intrastate level. A subsidy exists if the costs attributable to the NTS portion of the local switching equipment do not vary with the level of usage by the customer but those costs are allocated and recovered through usage sensitive rates. High volume users of interstate switched services would be subsidizing low-volume users. NYNEX has indicated that approximately twenty percent of the interstate local switching costs were NTS switching costs associated with terminations of local loops. The separations process currently allocates switching costs based on the usage sensitive DEM factor. The per minute charge for the interstate local switching access element also does not differentiate between NTS and traffic-sensitive switching costs. II. History The current treatment of local switching costs under the separations procedures began in 1988. For the sixteen years prior to that date, the Commission's separations rules had recognized that switching equipment imposed NTS and traffic-sensitive costs, although the access charge rules had assessed a usage-based line termination charge since 1984 to keep the CCL rate lower. The pre-1988 separations procedures had divided the cost of local switching equipment into NTS and traffic-sensitive components by applying an equipment factor based on the particular type of switch installed in the office and the size of the office. As was the case with loop plant, the cost of NTS equipment was apportioned between the state and interstate operations by the application of a frozen subscriber plant factor ("SPF"). The SPF factor weighted subscriber line usage (the interstate holding time minutes of use compared to total holding time minutes) to allocate a larger sum to the interstate jurisdiction. In 1987 when the Joint Board recommended eliminating the requirement that carriers distinguish between NTS and traffic-sensitive costs of local switching equipment, the Joint Board stated "that with changing technology and the introduction of digital switching systems, the distinction between NTS and [traffic-sensitive costs in local switching had] become difficult to calculate and justify." The Joint Board concluded "that the benefits of maintaining the distinction between NTS and [traffic-sensitive costs for local switching were] outweighed by the benefits of the simplification that would result from eliminating [the] distinction." The Joint Board also noted that the existing NTS and traffic-sensitive studies were outdated and would be costly to redo. The Commission adopted the Joint Board recommendation and reasoning. The Commission stated that the recommended revisions of separations procedures would further its goal of simplifying the separations process. Specifically, the Commission stated that it believed that distinguishing between NTS and traffic-sensitive investment for local switching no longer remained reasonable. III. Critique Recovering NTS costs on a traffic-sensitive basis has been criticized on much the same basis as the recovery of a portion of the NTS common line costs through traffic- sensitive CCL charges. Incumbent LECs may find it difficult to retain on their switched network those customers with the highest levels of interstate traffic, because these high- volume customers may be required to pay more in interstate switching charges than the economic cost of using the switch. This permits competitors of a LEC to attract the high- volume customers by charging those customers a cost-based rate. As long as the competitor's costs and prices are lower than the prices produced by the LEC's package, particularly if it must recover NTS switching costs on a traffic-sensitive basis, a competitor will be able to offer customers a financially attractive alternative to the LEC's services. From the opposite perspective, some parties argue that recovery of NTS costs on a traffic-sensitive basis may also distort competition for those customers with the lowest volume of interstate traffic. Because these customers generate such low levels of interstate traffic, they do not contribute enough in switching charges to cover their actual interstate NTS switching costs. Hence, even new entrants using technologies that bring their costs below those of the incumbent LEC may not be able to match the subsidized prices charged by the LEC. This would inhibit such entrants from competing in these markets. It also has been argued that this pricing approach forces low-income individuals who make a relatively high level of interstate calls to subsidize wealthy individuals who do relatively little interstate calling. This could occur because the subsidies generated and distributed by the current switching charge are collected and distributed without any regard to a customer's income or wealth. IV. Positions of Major Interest Groups LECs. NYNEX supports modifying the manner in which NTS line-side terminating costs are recovered, arguing that the recovery of these costs through per minute usage rates requires it to charge rates that contain subsidy components that result in charges that exceed the relevant costs and that such pricing cannot be sustained in a competitive interstate access market. V. Sources The NYNEX Telephone Companies Petition for Waiver, Transition Plan to Preserve Universal Service in a Competitive Environment, Memorandum Opinion and Order, 10 FCC Rcd. 7445 (1995). MTS and WATS Market Structure, Amendments of Part 67 (New Part 36) of the Commission's Rules and Establishment of a Federal-State Joint Board, Report and Order, 2 FCC Rcd 2639 (1987). Amendment of Part 67 of the Commission's Rules and Establishment of a Joint Board, Recommended Decision and Order, 2 FCC Rcd 2551 (Joint Bd. 1987). Petition for Waiver of the NYNEX Tel. Cos. (filed Dec. 15, 1993) (summarized in Pleading Cycle Established for Comments on NYNEX's Petition for Waiver of Parts 61 and 69, Public Notice, 9 FCC Rcd 139 (1993)). Interim Transport Rate Structure I. Description In 1992, the Commission adopted interim rules governing the pricing of transport, which is the transmission path, including any intermediate switching, between LEC end offices and IXC networks. As part of the interim structure, a per-minute "interconnection charge" was established that was to be assessed on all persons interconnecting with the LEC switched access network. The rules require LECs to assess either flat-rated or per minute charges to recover the costs of the transport facilities, depending upon whether intermediate switching facilities are used. LEC initial flat-rated transport facility rates were generally presumed to be reasonable if they were based on the September 1, 1992, non-discounted rates for equivalent special access. For tandem-switched transport, the service carrying traffic between the serving wire center ("SWC"), or tandem office, and end offices that is switched at an access tandem switch, rates were generally presumed to be reasonable if they were based on a mix of the DS1 and DS3 rates for direct-trunked transport (the service carrying traffic over dedicated interoffice facilities that does not use tandem switching), assuming 9000 minutes of use per month per circuit and including twenty percent of the tandem revenue requirement. The interconnection charge is a residual amount calculated to permit LECs initially to recover the same level of total revenues under the new rules as they would have received under the prior rules. Thus, the sum of the revenues the LEC received for the transport links and the interconnection charge revenues were to equal the revenues the LEC would have received if the rules had not been changed. The interconnection charge recovers approximately seventy percent of the LECs' costs allocated to the transport category. Because it is a residual amount, the explanation for the costs included in the charge are often unclear. Some portion of the amount represents adjustments made to the transport rate structure that reduced the level of the charge that would otherwise have been assessed as the initial rate for transport that employs the tandem switch. The remainder of the costs included in the interconnection charge presumably result from the interplay of cost allocation procedures under the separations and access charge rules. To the extent that the costs included in the interconnection charge element result from rate structure adjustments that keep tandem-switched transport rates lower than they otherwise would be, the support flows to those IXCs, generally the smaller ones, that use tandem-switched transport relatively the most. Indirectly, support therefore also flows to their customers who pay lower rates than they otherwise would pay for their long-distance telephone service. The costs included in the interconnection charge that are not attributable to the transport rate structure explicitly, but arise there because of the separations and access charge regulatory processes, represent a support flow, the beneficiaries of which vary depending upon the nature of the cost misallocation. Funding. The subsidies are funded internally through the operation of the transport rate structure rules. Under these rules, any person that interconnects with the LEC switched access network is assessed the per minute interconnection charge. Thus, the interconnection charge is assessed primarily on IXCs for their use of the LEC access network to originate or terminate interstate calls, who then include the cost of the interconnection charge in developing their interstate toll rates. II. History In the 1983 Access Charge Order, as part of the proceeding developing the access charge structure that would apply to the LECs upon their divestiture from AT&T, the Commission adopted rules requiring LECs to allocate transport costs between dedicated transport and common transport. Those rules required the LECs to charge for dedicated transport on a flat-rated, per-line basis to reflect the NTS cost characteristics of the associated facilities. Common transport (as used in that proceeding, it represented the transmission between an access tandem and an end office) was to be charged on a usage- sensitive basis. Subsequently, the United States District Court for the District of Columbia entered the Modification of Final Judgment ("MFJ") implementing the divestiture of the Bell System. The MFJ included a requirement known as the "equal charge" rule, providing that from January 1, 1984, through September 1, 1991, the Bell Operating Companies ("BOCs") were required to charge an equal amount per minute for all IXC transport traffic. The Commission waived the rules adopted in the Access Charge Order for all LECs to enable the BOCs to comply with the equal charge rule. Upon expiration of the MFJ's equal charge rule, the Commission initiated the transport proceeding to revisit the transport rate structure. Pending the resolution of the transport proceeding, the Commission required the LECs to continue offering transport service under the terms of the equal charge rule. Goals. In adopting the interim rate structure, the Commission was guided by three goals: (1) to encourage efficient use of transport facilities by allowing pricing that reflects costs; (2) to adopt a rate structure conducive to full and fair interexchange competition; and (3) to avoid interference with the development of interstate access competition. Rejection of Equal Charge Rule. The Commission decided in the First Transport Order that continuing the equal charge rule was no longer in the public interest. That rule required the LECs to charge usage-sensitive rates even to access customers using dedicated facilities, the costs of which are not affected by the amount of traffic carried over them. Thus, the charges paid by these customers did not reflect the manner in which LECs incurred transport costs. The Commission also found that the equal charge rule also interfered with the development of efficient competition for interstate access service because LECs were forced to charge per-minute rates for services that their competitors (e.g., competitive access providers) would be able to price on a flat-rate basis. To replace the equal charge rule, the Commission decided that an interim transport rate structure was the best way to achieve its public interest goals in the near term. The interim rate structure includes both flat-rate elements and traffic-sensitive elements, better reflecting the manner in which LECs incur costs. The Commission set an expiration date of October 31, 1995, for the interim rate structure. The Commission also issued a Further Notice seeking comment on the appropriate long-term transport rate structure and pricing once the interim rate structure expires. The interconnection charge was established as a transitional mechanism, which the Commission tentatively concluded should ultimately be eliminated, except for those costs relating to clearly identified public policy goals. As part of the Further Notice, the Commission therefore asked LECs to quantify the costs included in the interconnection charge and sought comment regarding measures that could be taken to reduce the interconnection charge. The Interim Rate Structure. The interim rate structure includes both flat-rate and usage-sensitive elements. The flat-rate elements apply to: (1) entrance facilities, the service carrying traffic from the IXC point of presence ("POP") to the LEC SWC; and (2) direct- trunked transport. The interim rate structure also includes usage-sensitive charges for: (1) tandem-switched transport; and (2) the interconnection charge, calculated on a residual basis to enable the LECs initially to receive approximately the same revenues under the interim rate structure as they would have received under the old equal charge rate structure. The equal charge rates were assessed on a per minute basis, that included a distance-sensitive charge for interoffice transmission. Tier 1 LECs are required to adhere to all aspects of the interim rate structure. Non- tier 1 LECs were largely exempted from implementing the interim rate structure. They are, however, required to provide entrance facilities on a flat-rated basis if they provide them to an IXC. Non-tier 1 LECs are also required to offer flat-rated direct-trunked transport upon receipt of a bona fide request. Initial Pricing Rules. The initial rates for the entrance facilities and direct-trunked transport under the interim transport rate structure were generally presumed reasonable if they were based on the LECs' September 1, 1992, non-discounted rates for equivalent special access services, provided that such rates satisfy a benchmark DS3-to-DS1 ratio of 9.6-to-1 (See discussion infra pp. 115-116). For example, the rates for DS1 transport entrance facilities were to be based on the pre-existing non-discounted rates for DS1 special access circuits between POPs and SWCs. LECs with benchmark ratios below the 9.6-to-1 ratio all filed initial transport rates that complied with that ratio. Initial tandem-switched transport rates were presumed reasonable if set as a weighted per-minute equivalent of DS3 and DS1 direct-trunked transport plus a tandem charge set to recover twenty percent of the interstate tandem switch revenue requirement. The weighting of the initial tandem-switched transport rates reflected the copper and fiber mix in the LEC interoffice network as representative of the DS1 and DS3 usage of the interoffice network. The LECs initial tandem-switched transport rates generally were weighted more heavily by the lower DS3 rate than by the higher DS1 rate. The per minute rate was developed assuming 9000 minutes of use per circuit per month. The per minute tandem-switched transport rates are based on the airline distance between the serving wire center and the end office, even though the interoffice segment between the serving wire center and the tandem switch is dedicated to the use of a single IXC. Finally, the initial tandem-switched transport rates incorporate only twenty percent of the tandem switching revenue requirement derived through the separations process. As noted above, the initial interconnection charge was calculated on a residual basis to recover transport costs not recovered under the facility-based charges in the interim rate structure. The LECs used historical facility demand and configurations in calculating the interconnection charge. The interconnection charge recovers approximately seventy percent of the LECs' interstate transport revenue requirement. Ongoing Rates. Ongoing rates for price cap LECs are governed by specific basket and banding limitations, just like other access service offerings. Rate of return LECs cost- justify their access rates each year under the interim rate structure. As noted above, the Commission determined that the initial rates for the new switched transport rate elements should generally be presumed reasonable if they were based on the LECs' existing rates for comparable special access services. Several factors suggested that special access provided a rational framework for establishing initial transport rates. The Commission observed that the LECs offer special access and transport services using similar--and, in some cases, the same--network facilities. For example, LECs provide switched transport entrance facilities using the same circuits that they use to provide special access facilities between IXC POPs and LEC SWCs. Moreover, before the price cap system was implemented in 1991, LEC special access rate levels had been cost-supported by the LECs under the Commission's rate of return rules and subjected to the tariff review process. Finally, in adopting LEC price caps, the Commission specifically concluded that special access rate levels were a reasonable basis from which to launch a system of price cap regulation. Special access rate changes between 1991 and the transport restructure complied with the requirements of the LEC price cap rules. The Commission imposed a limited benchmark requirement on the setting of the initial transport rates to protect against possible adverse effects on smaller IXCs. To establish the appropriate benchmark, the Commission compared the LECs' rates for existing DS3 special access services with their rates for existing DS1 special access services. Most LEC rates for such DS3 services, which have twenty-eight times the capacity of DS1 services, were at least 9.6 times their rates for DS1 special access services. Thus, the Commission imposed a 9.6-to-1 benchmark requirement to ensure that those LECs with special access DS3-to-DS1 rate ratios that fell below most other LECs' rate ratios either provided cost justification for basing their initial restructured transport rates on their special access rates, or filed transport rates that complied with the benchmark ratio and certain other requirements. In the July 1993 First Reconsideration Order, the Commission modified the method to be used in calculating the interconnection charge to require the LECs to use historical facility demand and configurations, rather than projected demand after IXCs reconfigure their networks in response to the restructure, as it had required in the First Transport Order. The Commission did this because of the LECs' incentive to underestimate the projected demand for transport facilities and thereby inflate the interconnection charge, and because there was no method for the Commission or other parties to measure the accuracy of the LEC projections. The Commission stressed, however, that the initial interconnection charge was to be calculated on a residual basis to further the goal of a revenue-neutral rate restructure. To achieve an interconnection charge that was neither too high nor too low, the Commission stated that it would permit a mid-course adjustment to the interconnection charge. In the 1993 Second Reconsideration Order, the Commission adopted a technical correction to the rules that required price cap LECs to base their initial calculation of the interconnection charge on historical usage demand, instead of projected usage demand. Implementation. On September 1, 1993, the LECs filed tariffs offering transport services pursuant to the interim rate structure and pricing rules. These tariffs became effective on December 30, 1993. III. Critique of the Support The criticisms of the support associated with the interim rate structure fall into two broad categories: (1) the anti-competitive effects of the interconnection charge; and (2) the cost misallocations and interim transport pricing rules that create the interconnection charge. In this section, we address the concerns about the competitive effects of the interconnection charge. In the following section, we will focus on those cost allocations and pricing issues associated with the interim transport rules that generated some portion of the subsidy in the interconnection charge. By discussing the issue and the proposed resolutions together, we believe the discussion will be more understandable and less redundant. The criticisms of the amounts included in the interconnection charge that are related to more general cost allocation or pricing issues, rather than the interim transport rules, are addressed elsewhere in this report. Competitive Effects. The interconnection charge has been criticized as having a number of anti-competitive effects on the interstate telecommunications market, not all of them related to switched transport. The broadest criticism is that because some of these costs reflect subsidies to other services, the competitiveness of the market for these other services is skewed. If a service is under priced because of a subsidy, competitive entry is more difficult because the entrant is competing against LECs whose rates are below what they otherwise would be. Alternatively, if the LECs' rates are too high because of a subsidy, uneconomic competitive entry is encouraged. In either case, the optimal allocation of market resources will not be achieved and consumers as a whole will lose. Recovery of NTS Costs Through Traffic-Sensitive Mechanisms. The interconnection charge is subject to the same criticisms as the CCL charge. To the extent that some of the costs included in the interconnection charge are NTS in nature, recovery through a per minute pricing mechanism results in high-volume users subsidizing low-volume users, as occurs with the CCL charge. This may artificially depress the demand of the high-volume users, thereby reducing the total welfare produced by the telecommunications industry. Effects of Reduced Tandem-Switched Transport Rates. The adjustments to the interim rate structure that reduce the tandem-switched transport rates, such as only including twenty percent of the tandem switch revenue requirement and the use of 9000 minutes to develop the per minute tandem-switched transport rate, have the effect of reducing the relative total cost of switched transport for those IXCs that use relatively more tandem- switched transport. These are generally the smaller IXCs. Their customers benefit indirectly from rates lower than they would have been charged if the interim pricing rules had not adjusted the tandem-switched transport rates. Moreover, because all IXCs pay the interconnection charge, the total switched access rates for IXCs using relatively less tandem- switched transport are higher than they otherwise would be. Thus, it has been asserted that AT&T's customers are paying for smaller IXCs' customers to have lower rates. The smaller IXCs do not concede that the adjustments to the tandem-switched transport rates represent a subsidy, contending instead that an incremental pricing approach for the tandem switching costs would produce a smaller tandem switching charge than the twenty percent included under the interim transport pricing rules. To the extent that tandem switching is underpriced, the development of effective competition for tandem switching is impeded. Increased tandem-switched transport competition would help move tandem-switched transport rates towards a market-based price, thus preventing the LECs from setting tandem-switched transport rates too high. Moreover, to the extent that tandem-switched transport is underpriced, some IXCs have the incentive to use more tandem-switched transport than would be economically justified if the service was priced at its full cost. This could result in those IXCs deploying unnecessary direct-trunked transport facilities in the short-term until the tandem-switched transport pricing is corrected. IV. Proposals by Interested Parties for Changing the Subsidy The record in response to the Further Notice in the transport proceeding contains a variety of explanations for the size and makeup of the interconnection charge, as well as proposals to resolve the alleged cost misallocations. To the extent these relate to the effect of the interim transport rules on the interconnection charge, we discuss them in this section. More general cost allocation issues are discussed elsewhere in this report. Tandem Switching Costs in the Interconnection Charge. We turn first to the eighty percent of the tandem switching revenue requirement that are included in the interconnection charge as a result of the interim transport pricing rules. The LECs generally acknowledge that some of these costs are incurred in the provision of SS7, line information data base, and some other services. These costs are estimated at between ten and fifteen percent of the total tandem switching revenue requirement. The record developed in response to the Further Notice in the transport proceeding does not challenge this assessment, nor the LECs' proposal that these costs be reassigned to the local switching category. The treatment of the remaining costs of tandem switching included in the interconnection charge are (estimated at ten to fifteen percent of the interconnection charge revenue requirement) sharply disputed. Some LECs and most IXCs other than AT&T argue that the remaining tandem switching costs should be reallocated to the local switching category and recovered through local switching rates. These parties contend that the switching functions of the tandem are similar to, and to some extent indistinguishable from, local switching. Comptel, Wiltel, and some LECs argue that incremental costing principles, such as open network architecture principles, should be applied to the costing of the tandem switching function in switches jointly used to provide local switching and tandem switching. If this were done, they argue, the costs assigned to the tandem switching element would be less than the twenty percent the interim pricing rules assign to the tandem switching element. In addition, some small IXCs argue that a portion of tandem costs are attributable to the need for LEC tandem switches to accommodate direct-trunked transport peak period overflow traffic. These peak period costs, they claim, should be recovered from direct-trunked transport users. On the other hand, AT&T and some LECs argue that only tandem-switch users cause tandem costs. These parties contend that 100 percent of the tandem revenue requirement, other than that attributable to SS7 and other services using the tandem switch, should be recovered in the rates for tandem-switched transport. Additional Tandem-Related Multiplexing Costs. Several LECs state that the tandem-switched transport rates do not recover all of the multiplexing costs incurred in providing tandem-switched service. Tandem-switched transport generally requires two multiplexers at the tandem. While direct-trunked traffic uses some intermediate multiplexing, it does not require an average of two intermediate multiplexers, as does tandem-switched transport. Thus, the transmission facility rates do not include all of the costs of these additional multiplexers that are necessary to provide tandem-switched transport. The record does not provide a good estimate of the size of this component. Use of 9000 Minutes in Calculating the Per Minute Tandem-Switched Transport Charge. In the First Transport Order, the Commission directed the LECs to use 9000 minutes of use ("MOU") per circuit in converting flat-rated direct-trunked transport rates into usage sensitive tandem-switched transport rates. Ameritech and SW Bell contend that their tandem-switched transport circuits average significantly less than 9000 MOU per month. The result, LECs argue, is that tandem-switched transport rates under recover the tandem-switched revenue requirement, with the difference being recovered in the interconnection charge. This problem is most evident in rural areas where tandem-switched transport is used most often and circuit utilization tends to be lower. These parties would allow the LECs to use their actual tandem circuit MOUs in developing their tandem-switched transport rates. Use of Airline Miles. Bell Atlantic claims that by computing tandem-switched transport mileage based on airline mileage between the serving wire center and the end office, rather than including any additional mileage incurred in tandem-routing, tandem-switched transport rates fail to recover the full costs of tandem-switched transport. These costs, it claims, are buried in the interconnection charge. Smaller IXCs assert that many LEC direct-trunked transport trunks pass through an intermediate office, often the same office as the tandem office, and that airline mileage is used to measure those trunks. Thus, they contend that there is no justification for Bell Atlantic's assertion. The smaller IXCs further contend that the LEC decision on tandem placement does not optimize interstate transmission needs and that factoring the tandem location into the distance calculation would adversely affect the smaller IXCs who make the greatest use of tandem-switched transport. Overhead Misallocations. Bell Atlantic, BellSouth, and SW Bell contend that part of the interconnection charge is attributable to overhead costs that are allocated to transport by the separations process and are not recovered under the new transport rates. This misallocation, they state, occurs because most transport rates are now flat-rated, while overhead costs associated with transport facilities continue to be allocated on a per-minute basis. They argue that interstate usage is concentrated disproportionately in a small percentage of customers, and that, therefore, the number of interstate minutes carried on many direct-trunked transport circuits significantly exceeds the average minutes per circuit in the transport network. Interstate minutes in excess of the average minutes per circuit do not produce revenues to cover any costs and are not offset by the flat-rated facilities with below average minutes. These minutes, however, are used in the separations and Part 69 cost allocation processes to allocate the cost of all transport facilities that are jointly used to carry both interstate and intrastate traffic. V. Positions of Major Interest Groups Regarding the Subsidy The parties commenting on the Further Notice agree that the interconnection charge should be reduced as soon as possible. Many of the parties also support the need for broad access reform. Considerable disagreement exists, however, over the means to be used to reduce the interconnection charge. Large LECs. The large LECs are the strongest proponents of broad access reform to address these and other subsidy issues. They are divided on the best manner to address the non-SS7 related tandem switching costs included in the interconnection charge. Some would move the revenue requirement to the local switching category, while others would move it into the tandem-switched transport category. Most larger LECs would also move from the assumed 9000 minutes per circuit to the actual MOU in calculating the tandem-switched transport per minute rate. Small LECs. Smaller LECs, who are not subject to the interim rate structure, do not have a strong view on the subject of how to eliminate or reduce the size of the interconnection charge. IXCs. AT&T urges shifting the tandem-switched transport related revenue requirement included in the interconnection charge to the tandem-switched transport category. AT&T also supports identifying any explicit public policy support amounts and recovering them in a revenue neutral manner. Smaller IXCs oppose recovering the tandem switching costs from an increased tandem switching charge, favoring moving those revenue requirements to the local switching category. Competitive Access Providers. MFS supports reducing the interconnection charge by allocating the costs to other rate elements, including elements subject to competition (such as entrance facilities, direct-trunked transport, and special access) and monopoly services, finding the interconnection charge to be an impediment to fair competition in the long- term. VI. Sources United States v. American Tel. & Tel. Co., 552 F. Supp. 131 (D.D.C. 1982), aff'd sub nom. Maryland v. United States, 460 U.S. 1001 (1983). Transport Rate Structure and Pricing; Petition for Waiver of the Transport Rules filed by GTE Service Corp., Report and Order and Further Notice of Proposed Rulemaking, 7 FCC Rcd 7006 (1992), recon., Transport Rate Structure and Pricing, First Memorandum Opinion and Order on Reconsideration, 8 FCC Rcd 5370, further recon., Second Memorandum Opinion and Order on Reconsideration, 8 FCC Rcd 6233 (1993), further recon., Third Memorandum Opinion and Order on Reconsideration in CC Dkt. No. 91-213, FCC 94-325 (Dec. 22, 1994) (summarized in 60 Fed. Reg. 4,107 (1995)). MTS and WATS Market Structure; Transport Rate Structure and Pricing, Order and Further Notice of Proposed Rulemaking, 6 FCC Rcd 5341 (1991). Policy and Rules Concerning Rates for Dominant Carriers, Second Report and Order, 5 FCC Rcd 6786 (1990), modified on recon., Order on Reconsideration, 6 FCC Rcd 2637 (1991), aff'd sub nom. National Rural Telecom Ass'n v. FCC, 988 F.2d 174 (D.C. Cir. 1993), petitions for further recon. dismissed, 6 FCC Rcd 7482 (1991), further modified on recon., Amendments of Part 69 of the Commission's Rules Relating to the Creation of Access Charge Subelements for Open Network Architecture; Policy and Rules Concerning Rates for Dominant Carriers, Report and Order and Order on Further Reconsideration and Supplemental Notice of Proposed Rulemaking, 6 FCC Rcd 4524 (1991), further recon., Memorandum Opinion and Order on Second Further Reconsideration, 7 FCC Rcd 5235 (1992). MTS and WATS Market Structure, Memorandum Opinion and Order, 50 Fed. Reg. 9633 (1985). MTS and WATS Market Structure, Third Report and Order, 93 FCC 2d 241, modified on recon., Memorandum Opinion and Order, 97 FCC 2d 682 (1983), modified on further recon., Memorandum Opinion and Order, 97 FCC 2d 834, aff'd in principal part and remanded in part sub nom. National Ass'n of Regulatory Util. Comm'rs v. FCC, 737 F.2d 1095 (D.C. Cir. 1984), cert. denied, 469 U.S. 1227 (1985), modified on further recon., Memorandum Opinion and Order, 99 FCC 2d 708 (1984), Memorandum Opinion and Order, 101 FCC 2d 1222, aff'd on further recon., Memorandum Opinion and Order, 102 FCC 2d 849 (1985). American Tel. & Tel. Co. Petition for Waiver of Sections 69.1(b), 69.3(e), 69.4(b)(7) and (8), 69.101, 69.111 and 69.112 of the Commission's Rules and Regulations, Memorandum Opinion and Order, 94 FCC 2d 545 (1983), recon., MTS and WATS Market Structure, Memorandum Opinion and Order, 97 FCC 2d 834 (1984). Local Exchange Carrier Switched Local Transport Restructure Tariffs, Order, 9 FCC Rcd 400 (Com. Car. Bur. 1993). Commission Requirements for Cost Support Material to be Filed with 1990 Annual Access Tariffs, Order, 5 FCC Rcd 1364 (Com. Car. Bur. 1990). Comments of Ameritech, AT&T, Bell Atlantic, BellSouth, GTE, MFS, NYNEX, Pacific, Southwestern Bell, Sprint, USTA, US West, and Wiltel to the Further Notice of Proposed Rulemaking (responding to Transport Rate Structure and Pricing; Petition for Waiver of the Transport Rules filed by GTE Service Corp., Report and Order and Further Notice of Proposed Rulemaking, 7 FCC Rcd 7006 (1992)). Comments of Comptel, in CC Dkt. No. 91-213 (Transport Rate Structure and Pricing). VII. Background Sources Expanded Interconnection with Local Telephone Company Facilities, Memorandum Opinion and Order, 9 FCC Rcd 5154 (1994). Expanded Interconnection with Local Telephone Company Facilities, Third Report and Order, 9 FCC Rcd 2718 (1994). Expanded Interconnection with Local Telephone Company Facilities; Amendment of Part 36 of the Commission's Rules and Establishment of a Joint Board, Second Report and Order and Third Notice of Proposed Rulemaking, 8 FCC Rcd 7374, further recon., Expanded Interconnection with Local Telephone Company Facilities, Second Memorandum Opinion and Order on Reconsideration, 8 FCC Rcd 7341 (1993). Expanded Interconnection with Local Telephone Company Facilities; Amendment of the Part 69 Allocation of General Support Facility Costs, Report and Order and Notice of Proposed Rulemaking, 7 FCC Rcd 7369, recon., Memorandum Opinion and Order, 8 FCC Rcd 127 (1992), vacated in part and remanded sub nom. Bell Atlantic Tel. Cos. v. FCC, 24 F.3d 1441 (D.C. Cir. 1994). Other Areas to Investigate I. Central Office Equipment Maintenance Expenses The separations process allocates central office equipment ("COE") maintenance expenses--which include expenses associated with circuit equipment, switching, and operator services--among the separations categories on the basis of the apportionment of total COE investment that is allocated to each category. These expense allocations are then carried over into Part 69 and allocated among the interexchange and access categories. Most of the larger LECs argue that each type of expense should be allocated among the various separations categories based on the allocation of the investment associated with that type of expense, rather than total COE investment. Thus, they would allocate circuit equipment based on the separations allocation of circuit equipment investment. Parties allege that the present system overallocates COE maintenance costs to transport. They allege that this change would move dollars from the interconnection charge (estimated to be between three and five percent of the interconnection charge amount) into local switching and common line categories. To the extent that the current allocation procedure under-allocates NTS costs to a category that recovers those costs on a traffic sensitive basis, the same uneconomic, distorting effects result as result from the recovery of common line costs through the traffic- sensitive CCL charge. II. General Support Facility Costs The General Support Facilities ("GSF") investment category in Part 36 includes some computer investment that is used by the LECs to provide nonregulated interstate billing and collection services. The costs of providing interstate billing and collection service are not removed from regulated service costs by Part 64 because many states still regulate intrastate billing and collection services. The separations process allocates these costs to the various separations categories based on the separations of the big three expenses (plant specific expenses, plant non-specific expenses, and customer operations expenses). Part 69 allocates GSF investment among billing and collection, interexchange, and the access elements based on the amount of COE, cable and wire facilities ("CWF"), and information origination/termination equipment ("IO/T") investment allocated to each Part 69 category. Since no COE, CWF, or IO/T investment is allocated to billing and collection, however, no GSF investment gets allocated to billing and collection. Likewise, since expenses related to GSF investment are allocated in the same manner as GSF investment, none of the related computer expenses get allocated to billing and collection. As a result, the computer investment and expenses are allocated to the other Part 69 categories. Several parties have proposed to amend Part 69, Part 32, Part 64, or Part 36 of the Commission's rules to ensure that GSF investment and related expenses are allocated to the billing and collection category. Making this amendment to the rules would shift some costs from interstate access services to the nonregulated billing and collection category, thereby reducing the cost of access. III. Method of Circuit Termination Counting for Central Office Equipment Category 4 Circuit Equipment Allocations The separations rules allocate COE circuit equipment costs to message and private line categories as follows. First, wideband costs are directly assigned to wideband private line. Second, other circuit equipment costs are allocated between private line and message circuit equipment, which in turn are allocated to message and voice grade private line, based on the number of circuit terminations. Tandem switched transport is deemed to involve three circuit terminations (entering and leaving the tandem and at the end office), while voice-grade special access and direct-trunked transport have only one circuit termination (at the end office). Tandem-switched transport, although somewhat more costly than special access and direct-trunked transport, may not generate three times the circuit equipment costs. Some parties assert that the allocation of COE Category 4 circuit equipment costs may result in over-allocating costs to transport and under-allocating costs to special access. While this problem has its roots in jurisdictional separations, any distortion caused in the separations process may be relatively insignificant since most facilities are used for both interstate and intrastate services. Thus, assuming relatively constant interstate and intrastate usage among services, the jurisdictional allocation would not be significantly altered by more precision. Rather, the problem may be more one of interservice misallocations when a particular facility configuration is used for some services but not for others. Thus, if direct-trunked transport accounts for one-third more of the circuit equipment costs than tandem-switched transport, then the result would be that costs are being over-allocated to transport and under-allocated to voice-grade special access. IV. Treatment of Enhanced Service Providers The enhanced service provider ("ESP") exemption permits those entities providing enhanced services on an interstate basis to pay for local business lines and thus avoid paying interstate access charges. The exemption arose when the Commission formulated its access charge rules, in 1983, because many interstate service providers, including certain ESPs, were using local business lines to obtain access to the local exchange for their interstate traffic. The rates for such local business lines were typically well below the rates that would have applied if ESPs were treated as common carriers under the Commission's access charge rules. The Commission was concerned that the immediate imposition of access charges on these service providers might unduly burden their operations and cause disruptions in service to the public. To avoid a rate shock, the Commission permitted these interstate service providers to use local business lines or other state-tariffed forms of access for their interstate traffic, thereby exempting them from federal access charges. By 1987 the Commission had eliminated the exemption for several classes of service providers, and it proposed to eliminate the exemption for ESPs, but in its 1988 decision, the Commission decided to continue the exemption, because it found that the ESP industry was entering a unique period of rapid and substantial change. In 1989 the Commission raised the issue of whether to modify the ESP exemption, but in 1991 rejected all proposed alternative options. Furthermore, some ESP customers are using ESP network connections to transmit interstate voice telephone calls rather than using IXCs. Opponents of the exemption, particularly IXCs, continue to argue that it is unfair to exempt ESPs from access charges, because that forces those who do pay them to pay more than their fair share. The ESPs argue that they ought not be required to pay interstate access charges because those charges were designed to apply to common carriers that use common lines to obtain access to IXCs. The ESPs maintain that they are not common carriers and that much of their interstate traffic is carried over private, rather than common, lines. V. Sources Amendments of Part 69 of the Commission's Rules Relating to the Creation of Access Charge Subelements for Open Network Architecture; Policy and Rules Concerning Rates for Dominant Carriers, Report and Order and Order on Further Reconsideration and Supplemental Notice of Proposed Rulemaking, 6 FCC Rcd 4524 (1991). Amendments of Part 69 of the Commission's Rules Relating to Enhanced Service Providers, Order, 3 FCC Rcd 2631 (1988). MTS and WATS Market Structure, Memorandum Opinion and Order, 97 FCC 2d 682 (1983), modified on further recon., Memorandum Opinion and Order, 97 FCC 2d 834, aff'd in principal part and remanded in part sub nom. National Ass'n of Regulatory Util. Comm'rs v. FCC, 737 F.2d 1095 (D.C. Cir. 1984), cert. denied, 469 U.S. 1227 (1985). Lawrence M. Fisher, Long-Distance Phone Calls on the Internet, N.Y. TIMES, Mar. 14, 1995.