SBC requests an order striking limited portion of the Rebuttal Declaration of Kevin Landis, filed on March 12, 2003 on behalf of Joint Applicants. SBC contends that certain claims in the Landis declaration are factually incorrect because he did not respond fully and completely to the discovery requests of SBC regarding the source code, data, and algorithms that underlie HAI Model 5.3 (HM 5.3) customer locations and clusters of customers. SBC maintains that the accuracy of Mr. Landis' claims on this topic cannot be verified without access to the source code, data, and algorithms that Joint Applicants have not produced. Thus, SBC asks that these statements be stricken.
Joint Applicants respond that Mr. Landis' rebuttal declaration responds directly to criticisms leveled by SBC's declarant Christian Dippon and should not be stricken. (See Dippon Reply Declaration, 2/7/03.) Joint Applicants claim they provided SBC with all the information it requested and more than enough information to evaluate the impact of the customer location database and clusters of customers within HM 5.3. For example, they point out that Mr. Dippon performed his own detailed analysis and evaluation of the customer location database and he was able to create alternative customer location databases to run through the HM 5.3 model.
According to Joint Applicants, SBC's motion to compel access to customer location database information was handled at a November 26, 2002 law and motion hearing wherein the assigned ALJ ordered Joint Applicants to provide SBC access to Mr. Landis and to let the ALJ know if further issues regarding the motion to compel needed to be resolved. Joint Applicants contend that they provided the ordered access to Mr. Landis and SBC later stated that it was "done with Kevin [Landis]." (Joint Applicants' Response to Motion to Strike, 4/28/03, Attachment D.) At no time did SBC return to the ALJ under the procedure she had outlined, for a further order compelling production of customer location source code, data, or algorithms. Therefore, Joint Applicants state it would be improper to strike portions of Mr. Landis' declaration on the grounds that he did not comply with discovery requests. Further, Joint Applicants claim that the source code, data, and algorithms are not needed to evaluate the impact of the customer location database on HM 5.3. SBC has all the information it needs to verify Mr. Landis' statements.
SBC's motion to strike portions of the Landis declaration is denied. Joint Applicants are correct that the ALJ ordered Joint Applicants to provide access to Mr. Landis and asked the parties to let her know if further disputes regarding the motion to compel on the customer location database issues would need her attention.4 SBC did not request the ALJ to issue a further order compelling production of the source code, data, and algorithms. I note that SBC Pacific states in its reply comments that "Mr. Dippon identified a series of errors and flaws in the customer location database" and that the "clustering algorithm is severely flawed and generates clusters in a randomized fashion that bear no resemblance to real world customer groupings. (SBC Pacific Reply Comments, 2/7/03, p. 31.) Apparently Mr. Dippon was able to perform significant analysis of the customer location database and its algorithms even without access to the source code, data and algorithms. The objections to the Landis declaration will go to the weight of the evidence. Joint Applicants contend that Mr. Landis' statements can be verified without access to the information that SBC describes. If Commission staff and the ALJ find this claim is not accurate as our scrutiny of the cost models continues, then Mr. Landis' statements will be given less weight.
Accordingly, IT IS RULED that:
1. Joint Applicants' February 7, 2003 motion to strike portions of the Declaration of Dr. Aron is granted in part, and denied in part, as shown in Attachment 1 to this ruling.
2. Joint Applicants' April 10, 2003 motion to strike is denied.
3. Joint Applicants' April 11, 2003 motion to strike is denied.
4. SBC Pacific's April 11, 2003 motion to strike is denied.
Dated May 21, 2003, at San Francisco, California.
/s/ DOROTHY J. DUDA
Dorothy J. Duda
Administrative Law Judge
BEFORE THE PUBLIC UTILITIES COMMISSION OF THE STATE OF CALIFORNIA
Joint Application of AT&T Communications of California, Inc. (U 5002 C) and WorldCom, Inc. for the Commission to Reexamine the Recurring Costs and Prices of Unbundled Switching in Its First Annual Review of Unbundled Network Element Costs Pursuant to Ordering Paragraph 11
(Filed February 21, 2001)
Application of AT&T Communications of California, Inc. (U 5002 C) and WorldCom, Inc. for the Commission to Reexamine the Recurring Costs and Prices of Unbundled Loops in Its First Annual Review of Unbundled Network Element Costs Pursuant to Ordering Paragraph 11
(Filed February 28, 2001)
Application of The Telephone Connection Local Services, LLC (U 5522 C) for the Commission to Reexamine the Recurring Costs and Prices of the DS_3 Entrance Facility Without Equipment in Its Second Annual Review of Unbundled Network Element Costs Pursuant to Ordering Paragraph 11 of D.99_11_050.
(Filed February 28, 2002)
Application of AT&T Communications of California, Inc. (U 5002 C) and WorldCom, Inc. for the Commission to Reexamine the Recurring Costs and Prices of Unbundled Interoffice Transmission Facilities and Signaling Networks and Call_Related Databases in Its Second Annual Review of Unbundled Network Element Costs Pursuant to Ordering Paragraph 11 of D.99_11_050.
(Filed February 28, 2002)
Application of Pacific Bell Telephone Company (U 1001 C) for the Commission to Reexamine the Costs and Prices of the Expanded Interconnection Service Cross_Connect Network Element in the Second Annual Review of Unbundled Network Element Costs Pursuant to Ordering Paragraph 11 of D.99_11_050.
(Filed February 28, 2002)
Application of XO California, Inc. (U 5533 C) for the Commission to Reexamine the Recurring Costs of DS1 and DS3 Unbundled Network Element Loops in Its Second Annual Review of Unbundled Network Element Costs Pursuant to Ordering Paragraph 11 of D.99_11_050.
(Filed March 1, 2002)
DECLARATION OF DR. DEBRA J. ARON
ON BEHALF OF
PACIFIC BELL TELEPHONE COMPANY
October 18, 2002
Table of Contents
I. INTRODUCTION 1
II. EXISTING UNE PRICES ARE NOT COMPENSATORY 4
III. THE TELRIC APPROACH IN CALIFORNIA 32
Q1. PLEASE STATE YOUR NAME AND POSITION.
A1. My name is Debra J. Aron. I am the Director of the Evanston office of LECG, LLC, and Adjunct Associate Professor at Northwestern University. My business address is 1603 Orrington Avenue, Suite 1500, Evanston, IL, 60201.
Q2. PLEASE DESCRIBE LECG, LLC.
A2. LECG is an economics and finance consulting firm that provides economic expertise for litigation, regulatory proceedings, and business strategy. Our firm comprises more than 300 economists from academe and business, and has 15 offices in six countries. LECG's practice areas include antitrust analysis, intellectual property, and securities litigation, in addition to specialties in the telecommunications, gas, electric, and health care industries.
Q3. PLEASE DESCRIBE YOUR PROFESSIONAL QUALIFICATIONS.
A3. I received a Ph.D. in economics from the University of Chicago in 1985, where my honors included a Milton Friedman Fund fellowship, a Pew Foundation teaching fellowship, and a Center for the Study of the Economy and the State dissertation fellowship. I was an Assistant Professor of Managerial Economics and Decision Sciences from 1985 to 1992, at the J. L. Kellogg Graduate School of Management, Northwestern University, and a Visiting Assistant Professor of Managerial Economics and Decision Sciences at the Kellogg School from 1993-1995. I was named a National Fellow of the Hoover Institution, a think tank at Stanford University, for the academic year 1992-1993, where I studied innovation and product proliferation in multiproduct firms. Concurrent with my position at Northwestern University, I also held the position of Faculty Research Fellow with the National Bureau of Economic Research from 1987-1990. At the Kellogg School, I have taught M.B.A. and Ph.D. courses in managerial economics, information economics, and the economics and strategy of pricing. I am a member of the American Economic Association and the Econometric Society, and an Associate member of the American Bar Association. My research focuses on multi-product firms, innovation, incentives, and pricing, and I have published articles on these subjects in several leading academic journals, including the American Economic Review, the RAND Journal of Economics, and the Journal of Law, Economics, and Organization. I currently teach a graduate course in the economics and strategy of communications industries at Northwestern University.
I have consulted on numerous occasions to the telecommunications industry on competition, costing, pricing, and regulation issues in the U.S. and internationally. I have testified in several states regarding economic and antitrust principles of competition in industries undergoing deregulation; measurement of competition in telecommunications markets; the proper interpretation of Long Run Incremental Cost and its role in pricing; the economic interpretation of pricing and costing standards in the Telecommunications Act of 1996 ("TA96" or "the Act"); limitations of liability in telecommunications; Universal Service; and proper pricing for mutual compensation for call termination. I have testified in a number of states on issues pertaining to broadband markets, broadband deployment, and incentives for broadband investment. I have also submitted affidavits to the Federal Communications Commission ("FCC") analyzing the merits of SBC Ameritech Michigan's application for authorization under Section 271 of the Telecommunications Act to serve the in-region interLATA market, CC Docket No. 97_137; explaining proper economic principles for recovering the costs of permanent local number portability, CC Docket No. 95-116; explaining the economic meaning of the "necessary and impair" standards for determining which elements should be required to be unbundled under TA96, CC Docket No. 96-98; and an analysis of market power in support of Ameritech's petition for Section 10 forbearance from regulation of high-capacity services in the Chicago LATA, CC Docket No. 95-65. I have consulted to carriers in Europe, the Pacific, and Latin America on interconnection and competition issues, and have consulted on issues pertaining to local, long distance, broadband, wireless, and equipment markets. I have conducted analyses of mergers in many other industries under the U.S. Department of Justice and FTC Merger Guidelines. In addition, I have consulted in other industries regarding potential anticompetitive effects of bundled pricing and monopoly leveraging, market definition, and entry conditions, among other antitrust issues, as well as matters related to employee compensation and contracts, and demand estimation. In 1979 and 1980, I worked as a Staff Economist at the Civil Aeronautics Board on issues pertaining to price deregulation of the airline industry. In July 1995, I assumed my current position at LECG. My professional qualifications are detailed in my curriculum vitae, which is submitted as Schedule DJA-1.
Q4. HAVE YOU PREVIOUSLY TESTIFIED BEFORE THE CALIFORNIA PUBLIC UTILITIES COMMISSION ("COMMISSION")?
A4. Yes. I testified on behalf of SBC Pacific Bell on issues related to proposed unbundling of the Company's broadband infrastructure.5
Q5. WHAT IS YOUR UNDERSTANDING OF THIS PROCEEDING?
A5. I understand that SBC Pacific Bell ("Pacific Bell" or "the Company") is filing cost studies and supporting documentation and testimony for certain unbundled network elements ("UNEs") that are the subject of the California Public Utilities Commission's ("CPUC" or "Commission") annual reexamination of UNE costs for the purpose of determining UNE prices.
Q6. WHAT IS THE PURPOSE OF YOUR TESTIMONY?
Q7. DR. ARON, PLEASE PROVIDE AN OVERVIEW OF THE COMPANY'S CURRENT UNE PRICES IN CALIFORNIA.
A7. In California, the method of pricing Pacific Bell's UNEs ostensibly has been based on forward-looking engineering assumptions about the configuration of a hypothetical network composed of the best, most efficient technology currently available, assuming the existing placement of the Company's wire centers. I will discuss how the improper application of the Federal Communications Commission's ("FCC's") total element long-run incremental cost ("TELRIC") methodology to Pacific Bell has resulted, however, in the omission of legitimate forward-looking costs I conclude that the Company's current UNE prices reflect a misapplication of the FCC's TELRIC methodology In fact, I show:
· Pacific Bell's interim UNE loop ("UNE-L") and platform ("UNE-P") prices are among the lowest in the nation;
Q8. HOW DO PACIFIC BELL'S CURRENT UNE PRICES IN CALIFORNIA COMPARE TO THOSE IN THE REST OF THE U.S.?
A8. According to an analysis by investment house Commerce Capital Markets ("CCM"), Pacific Bell's interim prices for unbundled loops and the platform are among the lowest of the 48 states.6 (See Charts 1 and 2).
Q17. ARE THESE REDUCTIONS IN CAPITAL SPENDING WHAT ONE WOULD EXPECT AS COMPETITION TAKES HOLD IN A MARKET?
A17. No, not necessarily. If prices are compensatory, Pacific Bell will have the incentive to sell UNEs to buyers, to upgrade its network, and to make a business of wholesale network elements even under very competitive conditions. Moreover, economically-priced UNEs will improve the viability of facilities-based CLECs, thereby improving the diversity of networks and services. Compensatory UNE prices are a necessary component to reestablishing health to the telecommunications marketplace.
Q18. ARE YOU ASKING THE COMMISSION TO GUARANTEE A PROFIT FOR PACIFIC BELL?
Q19. DR. ARON, DO THE 1996 TELECOMMUNICATIONS ACT AND THE FCC'S PRICING RULES IMPLEMENTING THE ACT NECESSARILY RESULT IN NON-COMPENSATORY UNE PRICES?
A19. I am not an attorney, nor do I seek to render a legal opinion, but my reading of the plain language of the 1996 Act and the Supreme Court's recent opinion in the Verizon case is that the FCC's TELRIC-based pricing methodology must be understood to permit compensatory prices, through the proper selection of inputs to reflect the idealized assumptions of the FCC's TELRIC model. In fact, the Court rejected incumbent carriers' argument that the FCC's TELRIC-based pricing model, even when properly applied, does not permit recovery of costs associated with increased risk and shortened asset lives. According to the Court:
The argument, however, rests upon a fundamentally false premise, that the TELRIC rules limit the depreciation and capital costs that rate setting commissions may recognize. In fact, TELRIC itself prescribes no fixed percentage rate as risk-adjusted capital costs and recognizes no particular useful life as a basis for calculating depreciation costs. On the contrary, the FCC committed considerable discretion to state commissions on these matters.7
That is, the Court concluded that proper application of the FCC's TELRIC-based pricing methodology requires recognition and recovery of the costs the carriers would incur as a result of increased cost of capital, increased risk of sunk assets, and shorter asset lives associated with the hypothetical, idealized assumptions of the TELRIC methodology. It is not only within the purview of the state commission to ensure that these costs are recognized, it is the state commission that is charged with that task. In my opinion, if properly accounted for, it is likely that recognition of such costs would bring UNE prices towards or into a range where, on an expectational basis, they could be compensatory.
Q20. IS THERE A SOCIAL BENEFIT TO KEEPING UNE PRICES ARTIFICIALLY LOW SO AS TO ENCOURAGE COMPETITIVE ENTRY INTO CALIFORNIA?
A20. No. Encouragement in this manner is neither necessary nor desirable. Setting UNE prices below any reasonable level of cost to provide life support for some CLECs and a toehold for others is not in the public interest. Rather, it is manufacturing "synthetic" competition, to use the D.C. Circuit Court's term,8 and artificially assisting competitors, at the expense of genuine competition.
Q21. WHAT ARE THE SOCIAL COSTS OF ENGINEERING ARTIFICIALLY LOW UNE PRICES TO ENCOURAGE COMPETITIVE ENTRY?
A21. When telecommunications infrastructure is priced too low, one result is the deterioration of the infrastructure that occurs whenever prices are held below compensatory levels. The phenomenon is similar to what happens in cities subject to "rent control." Rent control holds prices below compensatory levels and results in (1) demand in excess of the social optimum; (2) supply that is less than the social optimum; (3) deterioration of the existing infrastructure; and (4) little or no investment in infrastructure.
Untenably low UNE prices based on a TELRIC study that uses unrealistic cost inputs lead to the rent control problem: High demand for UNEs relative to self-supply (provided that the retail price for telecommunications services is adequate to entice entry), and little or no new investment in infrastructure. Consumers are harmed in several ways:
· Genuinely new choices are not developed: CLECs do not develop them because they are better off using the existing network at cut-rate prices, and ILECs do not develop them because they would wind up bearing alone the costs of anything new that does not succeed in the marketplace, and sharing with CLECs, at non-compensatory prices, anything new that does succeed;9
· New technologies are ignored or even discouraged;
· Too little capital is invested in the existing infrastructure; external sources of such investment dry up; and economically rational ILECs become reluctant to invest in the network. And everyone loses, including UNE-based CLECs, if the ILEC network deteriorates as a result.
Furthermore, as with rent controls, once long-run economic decisions are made on the basis of uneconomically low prices, the effects of inefficient choices become costly to undo. In the subsidized housing context, this has resulted in the deterioration in the housing stock, depressed incentives to invest in new housing supply, and an artificial lack of mobility of renters who acquired a subsidized apartment. The same economic principles apply here. UNE prices that are uneconomically low encourage inefficient reliance on the existing network, which leads to inefficient and depressed incentives by all parties-incumbents and CLECs-to invest in the existing infrastructure, in new infrastructure, and in new technology.
Moreover, to the extent that elements are shared among competitors, there is reduced competition in the production of that element. Supreme Court Justice Stephen Breyer articulated this fact well when he wrote:
Nor are any added costs imposed by more extensive unbundling requirements necessarily offset by the added potential for competition. Increased sharing by itself does not automatically mean increased competition. It is in the unshared, not in the shared, portions of the enterprise that meaningful competition would likely emerge. Rules that force firms to share every resource or element of a business would create not competition, but pervasive regulation, for the regulators, not the marketplace, would set the relevant terms.10
It is a straightforward economic principle that the more that is shared, the less will be the competition along that particular dimension and the greater the call for additional regulation. CLECs that rely on the incumbent's network do not, by definition, provide any innovation in the provision of the underlying facilities. Accordingly, UNE-P and resale providers have fewer avenues by which to make contributions to the marketplace. The result is not only less investment, but also, very fundamentally, less competition.
Q22. ARE THERE OTHER SOCIAL COSTS OF ENCOURAGING "COMPETITION" THROUGH UNECONOMICALLY LOW UNE PRICES?
A22. Yes. Competitors that avail themselves of underpriced UNEs may come to view these UNEs as an entitlement, and may demand that underpriced UNEs continue to be available even after the justification for the unbundling of any particular element has disappeared, in order to preserve their valuable "options" on technology. This is a classic flaw associated with what is known as the "infant industry" argument.
Often implemented in the form of tariffs to protect a fledgling domestic industry from foreign competition, the infant industry rationale induces policy makers to bestow temporary preferential treatment on a certain industry or class of competitors in order to boost their ability to compete until the industry or competitors mature. In addition to distorting incentives to enter the market, the problem with infant industry protectionism is that it is very difficult to eliminate the preferential treatment once the infant industry is on its feet. As noted by economists Alfred Kahn and William Taylor:
[S]o long as companies are insulated from competition, they are, to that extent and for that reason, less likely ever to grow up and attain the ability to compete without such special protections. . . .
It takes very little imagination or information about the industry today and about the actual identity of the emerging new competitors of the LECs (such as of US West with Time Warner, of MCI with various cable systems and metropolitan competitive access providers, and of the ill-fated multi-billion dollar alliance of Bell Atlantic and TCI, the largest owner of cable systems in the country) to envision the consequences of a policy of introducing such systems of competitive handicaps of incumbents and preferences for entrants. History clearly justifies the prediction: if commissions adopt such recommended policies as identifying new entrants as struggling infants, they will continue to find themselves for years subject to similar entreaties by billion-dollar "infants," suitably diapered and with mendicant bowls in hand, continuing to play the game of regulatory rent-seeking, in order to avoid having their merits subjected to an unbiased market test.11
Kahn and Taylor vividly and accurately describe a key flaw in protectionist public policy towards new entrants: The protection depresses the protected firm's imperative to create unique and marketable value added for consumers. It is the creation of such value for consumers that provides the basis for firms to survive in competitive markets in the long run, and create value for the economy.
II. THE TELRIC APPROACH IN CALIFORNIA
Q23. ARE THERE PARTICULAR COST-DRIVERS THAT AFFECT TELRIC-BASED PRICES?
A23. Yes. I will comment on two significant ones: fill factors and stranded costs.
4 See Reporter's Transcript, 11/26/02, at 197 wherein the ALJ describes that Joint Applicants will "mak[e] Mr. Landis available for an additional eight hours to Pacific and their expert on the TNS algorithms, and hopefully they can resolve the data needs here. And if not, the parties will check back in with me after the workshop that we'll have in this proceeding on December 3rd."
5 Re Open Access and Network Architecture Development, Decision No. 96-08-021 (Aug. 2, 1996).
6 CCM reviewed 47 continental U.S. states (Connecticut was unavailable) and Washington, D.C. The numbers relied upon for the analyses that follow are a weighted average of zone-specific UNE-L (for Chart 1) and UNE-P (for Chart 2) prices as developed by investment analyst Dr. Anna Maria Kovacs. See Anna Maria Kovacs et al., "The Status of 271 and UNE-Platform in the Regional Bells' Territories," Commerce Capital Markets Equity Research, August 22, 2002, p. 1 (hereafter, "CCM August 2002"). The weights are the number of lines served by zone by the particular Bell operating company ("BOC").
7 Verizon at *34.
8 In its May 24 2002, opinion in United States Telecom Association v. FCC, the United States Court of Appeals for the District of Columbia Circuit characterized as "completely synthetic competition" that competition which is "performed with ubiquitously provided ILEC facilities" provided at "Commission-imposed prices [that] are highly attractive to CLECs." United States Telecom Association v. FCC et al., 290 F.3d 415, 424 (D.C. Cir. 2002) (hereafter, U.S. Telecom Association).
9 As the United States Court of Appeals for the District of Columbia Circuit observed in U.S. Telecom Association, "If parties who have not shared the risks are able to come in as equal partners on the successes, and avoid payment for the losers, the incentive to invest plainly declines." Id. at 424.
10 AT&T Corp. v. Iowa Utilities Board, 525 U.S. 366, 429 (1999) (Breyer, concurring in part and dissenting in part, concurring in relevant part).
11 Alfred E. Kahn and William E. Taylor, "The Pricing of Inputs Sold to Competitors: A Comment," 11 Yale Journal on Regulation 225-240 (footnote omitted).