March 30, 1995

Re: Price Cap Performance Review for Local Exchange Carriers

I regretfully but resolutely dissent. In my judgment, the ruling adopted today underestimates the ability of local telephone companies to increase the efficiency of their operations and shortchanges the interests of consumers. Four years ago, when price cap regulation for local telephone companies was initiated, the Commission's stated objective was that "[i]ncentive regulation will reward companies that become more productive and efficient, while ensuring that productivity and efficiency gains are shared with ratepayers." The Commission committed to a comprehensive review during the fourth year of the price cap regime and to make any necessary adjustments.

The promised review has been underway for more than a year. Today's ruling is the interim -- and far from fully successful -- result of our efforts.

Introduction. To review and revise our price cap rules presents us with formidable challenges. Even if we confine one stage of the effort to certain interim adjustments, the task of establishing new productivity factors and sharing rules requires us to evaluate complex evidence that is subject to conflicting interpretations. Each of us must make independent judgments on the record as we understand it.

My own conclusion is that today's ruling materially underestimates the productivity gains that can reasonably be expected of the large telephone companies. This miscalculation will lead directly to interexchange carriers paying more than they should for interstate access services, and indirectly to similarly adverse impacts on consumers. As a result, the Commission's ruling sends the wrong message to the local and long distance carriers, to the state regulators with whom we share responsibility for oversight of the telephone companies, and to the American public.

Today the Commission acknowledges that the productivity factors prescribed in 1990 were significantly and erroneously low. Through the "reinitialization" of price cap indices we ensure that this error -- to the extent it is now being corrected -- will not be compounded in future years. Yet, even with this experience, the Commission adopts overly modest productivity goals for the coming year or two, thereby setting the stage for future overearnings and future reinitializations.

Overlaid on these problems are the drawbacks of the Commission's decision to restructure the sharing options. Although the interim plan is intended simply as a short-term measure pending completion of the current rulemaking, the Commission now concludes that price cap companies should have three X-Factor options rather than two.

The consequence of these features of our interim plan is to reduce consumer benefits, increase uncertainty in the marketplace, and add unnecessary complexity to the framework. A far better approach would have been to change the structure less and the numbers more.

Unnecessary Complexity. I disagree with the decision to replace the present two-option model with a three-option model during this stage of the rulemaking. The drawbacks of this approach have not been adequately considered. A three-option model adds needless complexity and "churn," particularly in light of the brief expected life of this interim plan and the inability of any Commissioner to know, at this juncture, how many options will be included in the long-term structure to be formulated in the next phase of this proceeding.

In light of the potential disruption, I do not regard it as prudent to adopt such a significant change in the structure of the price cap regime at a time when we are not yet ready to settle upon a long-term plan. And I fear that the untested economic logic of a three-option model may impel carriers to hold back from reaching for the high option, the only one that eliminates the vestiges of rate-of-return regulation. To the extent we discourage carriers from pursuing the no-sharing option, we have lost an opportunity to move away from reliance on cost-accounting strictures and other trappings of traditional common carrier regulation.

Inadequate Productivity Expectations. More troublesome than the number of options are the specific X-Factors associated with the options, especially the low-option X. The new productivity factors are more aggressive than those in the current plan, but insufficiently so. Considerably greater productivity gains are readily attainable, particularly in light of the pace at which telecommunications technologies are advancing.

Indeed, the record contains substantial evidence that the productivity gains of local exchange carriers in the post-divestiture, pre-price cap era were above the lower X-Factor we are prescribing today.

The Commission's own Frentrup-Uretsky study (now corrected to exclude the aberrational 1984 data point) demonstrates that industry-wide productivity improved at a rate of 5.0 percent per annum over the years from 1985 to 1990. In other words, our own study of post-divestiture, pre-price cap performance demonstrates powerful trends toward increased productivity.

The USTA study is consistent with this finding. If corrected to account for differences in input prices, the USTA study presents highly consistent results -- 4.8 percent -- over a comparable time frame. Moreover, two of the most experienced state public service commissions, those in New York and in California, have approved price cap plans with productivity expectations in the 4.6-4.8 percent range.

These numbers are testimony to the prowess of our telecommunications industry and the powerful forces at work in cutting-edge technologies. The phenomenon known as Moore's Law ensures that the cost of computer processing power is halved every 18-24 months. The ever-increasing capabilities and ever-decreasing prices of switches and lasers and a wide array of other equipment provides a solid foundation for continued productivity growth throughout the communications and information industries.

One can, of course, "rework" the numbers in ways that support different conclusions. For example, in its 1990 decision, the Commission averaged the Frentrup-Uretsky study with a longer-term study, the Commission's Spavins-Lande study (1930-1989), which reflected much lower productivity gains. We now acknowledge, however, the need to revise the Frentrup-Uretsky, so even the methodology employed in 1990 would compel a new X- Factor and reinitialization requirement that is higher than is being adopted today.

An only slightly more probing reevaluation of the 1990 decision would justify a more substantial increase in the new low-option X-Factor. In my judgment, the Spavins-Lande study is not entitled to comparable consideration with the far more recent and relevant experience covered in the Frentrup-Uretsky study, so any departures from a 4.1 percent low- end X-Factor and a 3.2 percent reinitialization must logically be in an upward direction. Indeed, post-price cap studies -- using a variety of methodologies -- confirm that productivity gains have continued at significantly more than a 4.1 percent rate.

The Commission has previously said that price cap regulation is intended to create added incentives for productivity gains and to ensure that ratepayers share in the resulting benefits. Such objectives cannot be reconciled with the adoption of X-Factors which are based on expectations that the telephone companies' productivity gains under price caps will be lower than they were under rate-of-return regulation.

Nor can the 4.0 percent option be justified by the need to accommodate those companies whose capacity for productivity gains is significantly below the average. For such companies, there is an even lower rung on the ladder: the lower-formula adjustment mechanism.

There are a variety of reasons why certain companies may be unable to match their peers in productivity gains. For example, geography, competition, plant vintages, and quality of management are all real factors that may come into play. Whatever these limitations, our lower-formula adjustment mechanism ensures that these carriers are protected; within specified limits, the price cap index in each year can be increased to offset any earnings shortfall occurring in the preceding year. Thus, the modest low-option X-Factor adopted today cannot be defended in terms of concern for the lesser performers among the telephone companies.

We must not forget that our telephone companies are preparing to lead the world in the delivery of innovative, sophisticated, cost-effective communications and information services. I am fully confident that they are up to the challenges they will face, including the need to continue to increase productivity and efficiency at a pace greater than is contemplated by the interim plan adopted today.

Long-Range Objectives. As a matter of context, it is important to emphasize that today's decision is not intended to establish the plan for the next four years of price caps; it is merely an interim plan while we develop a more comprehensive record on certain issues that we have not yet had an opportunity to resolve. Disappointed as I am with the interim plan, I am ready to look forward to the longer term.

As we prepare for the next phase of this proceeding, two issues will be of special importance to me: elimination of sharing and promotion of competition.

I am determined to explore avenues that will enable us to eliminate the "sharing" aspects of price caps. Sharing perpetuates many of the less desirable features of rate-of-return regulation. Eliminating sharing is also a precondition for taking services out from under price cap regulation, as we have done for AT&T when competitive considerations warranted. I firmly believe that we can structure a regime which enables those companies which are willing to step up to the increased risk of a higher X-Factor to enjoy the rewards of keeping whatever profits they can generate.

On the other hand, if we fail to establish the right X-Factors, we cannot responsibly eliminate sharing. Certainly, given the highly cautious manner in which the original X- Factors were established, it is fortunate that the original plan included provisions for sharing.

Regarding competition, the Commission has tentatively decided to modify our price cap goals so as to promote, and not only replicate the effects of, competition in interstate access and other local communications services. I firmly support this decision. Whenever and wherever possible, I am committed to replacing regulation with competition. At the same time, I recognize that introducing competition where it currently is lacking cannot be achieved by wishful thinking.

Conclusion. As we continue our efforts, we have a responsibility to manage the transition carefully. We must avoid overregulation. Equally important, we must not abdicate our responsibilities while there remain significant problems of market power.

I know that we will confront many difficult issues as we move to the next step of the process. I look forward to the debate.