3. Parties' Position

By ruling dated February 23, 2007, we provided notice and opportunity for comment as to whether, or in what manner, basic residential rates should be modified as a function of revisions to the B-Fund mechanism adopted in D.07-09-020. By ACR dated October 5, 2007, parties' comments were solicited concerning a process for basic rate levels to transition from existing levels to a point at which further price restrictions can be eliminated, thereby allowing for full pricing flexibility. The record of written comments provides a sufficient basis for the reforms that we adopt.

Comments on basic rate transition issues were filed by each of the URF incumbent LECs, and also by Sprint Nextel (Sprint), the Division of Ratepayer Advocates (DRA), and The Utility Reform Network (TURN).

Parties' proposals differ as to: (1) the maximum cumulative increase in basic rates that would be "affordable," and whether a empirical study is necessary to determine a maximum affordable rate; (2) the maximum per-year increase in basic rates sufficient to avoid rate shock; (3) the length of the transition period before full pricing flexibility for basic service should be authorized; (4) whether or subject to what conditions, full pricing flexibility would be justified at all; and (5) what restrictions should apply to a COLR in the pricing of basic rates in high cost areas subsidized by the B-Fund.

3.1. AT&T

AT&T argues that pricing regulation of basic service distorts competitive choices and causes harm to consumers, and thus recommends a phase-in period for transitioning to market-based rates for local exchange service limited to no more than two years. AT&T recommends that the cumulative increase in basic rates over this two-year period be sufficient to allow the AT&T rate to be equal to the current SureWest rate, which is set at the highest level among the four ILECs. In calculating the resulting rate increase, AT&T incorporates its tariffed intrastate basic rate plus its federal End User Common Line or EUCL charge.24 Because the AT&T rate is lower than the SureWest rate, AT&T residential customers' maximum basic rate would consequently increase by $10.32, calculated as follows:

AT&T proposed to phase in the $10.32 increase in equal installments over a two-year period, with a $5.16 per-month increase beginning January 1, 2009, and an additional $5.16 per-month increase beginning January 1, 2010.25

AT&T Proposed Rate Cap:

January 1, 2009:

On a percentage basis, the $5.16 increase would represent an increase of 34.2% and 25.5% respectively over the two years. Assuming the first step of the basic rate cap increase were implemented beginning January 1, 2009, and the second step on January 1, 2010, AT&T proposes that it be granted full pricing flexibility for basic rates beginning on January 1, 2011. AT&T argues that this approach is reasonable because the resulting increase would bring AT&T rates for basic rate plus EUCL into line with what is already being charged to customers of SureWest.

Since AT&T California has not increased basic service rates since 1995, however (except for the single 2.36% cost of living increase allowed for 2008), the resulting increase would equate to less than a 5% annualized increase if it had been evenly distributed over the entire period since 1995. AT&T argues that the transitional pricing approach that it advocates is reasonable, taking into account the Commission's concerns over avoiding consumer rate shock while realizing the benefits of a competitive market.

3.2. Verizon

Verizon likewise argues that in order to minimize market distortions that result from price caps, the Commission should keep any transition period as short as possible. Verizon proposes a three-year phase-in period for transitioning to market-based rates for local exchange service.

Verizon believes that while the rate cap for basic service at the end of the transition period need not be increased up to the full $36 high-cost benchmark adopted in D.07-09-020, it should not be set so low as to risk rate shock once full pricing flexibility takes effect. Verizon thus proposes to increase the cap up to 50% of the difference between the $36 benchmark and the amounts each ILEC currently charges for basic service (including the EUCL).

The effects of Verizon's proposal on the basic rates for each of the ILECs is summarized below:

The resulting annual increase in Verizon's basic rate cap would be $5.92 (or 50% of $11.84, equal to the $36 benchmark- $17.66 rate + $6.50 EUCL). At the end of the three-year phase-in period, Verizon's cap would increase to $30.08. Verizon proposes to implement the increase by applying $1.97 annual increases for each of the three years to the basic service rate.

Applying Verizon's proposal would yield an annual increase of $3.45 in the AT&T basic rate in each of the three-year transition period. AT&T's annual increase would be relatively higher than Verizon's due to a lower starting point for applying the increases. After three years, the AT&T basic rate would increase to $25.66 (including the EUCL). At the end of the third year, under Verizon's proposal, remaining price caps would expire, and full pricing flexibility would take effect. Verizon argues that rate increases under its proposal are consistent with the magnitude of increases of $2.90 and $6.05 for AT&T and Verizon, respectively, that the Commission adopted in the Implementation Rate Design Proceeding in 1995, and should therefore raise no concerns over rate shock.

3.3. SureWest

SureWest supports annual step increases of between $1 and $2 in the monthly rate for basic service, representing an increase in the range of 10% to 20% for the URF ILECs. SureWest claims that such yearly increases would not result in rate shock to basic service subscribers. SureWest suggests that after a period of three-to-five years, the Commission could evaluate whether subsequent ongoing step increases were necessary or whether to permit full pricing flexibility on basic service.

3.4. Frontier

Frontier recommends that basic rates be allowed to increase up to $4 per year over a four-year period before full pricing flexibility takes effect. Frontier argues that a four year period is a reasonable interval during which to allow customers to adjust to higher basic rates. Frontier argues that the Commission should thereafter rely upon the competitive marketplace to dictate whether an URF company would elect any further increase in its basic rates.

3.5. TURN

TURN argues that before an informed judgment can be made concerning the maximum feasible adjustments in basic rates, the Commission must first conduct an investigation as to what constitutes affordable rates in California. TURN argues that the Commission needs to examine California-specific data as a basis to determine a maximum affordable rate cap. TURN proposes that Field Research be enlisted to undertake a modified version of the affordability study, which was one of the NRF monitoring reports eliminated in D.06-08-030.

TURN believes that a specific time period for a transition process is difficult to assess without knowing the maximum rate that would be affordable. Given that caveat, TURN proposes that any ILEC increases be limited to no more than the general rate of price inflation, measured by the Gross Domestic Product Price Index (GDP-PI). Alternatively, if the Commission chooses to increase rates by a greater amount, TURN proposes no more than a 10% per year increase over a five-year period. TURN further proposes that no carrier be permitted to charge rates that exceed 150% of the lowest rate that the service provider charges in other regions of its service territory. TURN notes that the overwhelming majority of states place some type of cap on basic rates, referencing a 2007 NRRI report regarding phone regulation in other states.

3.6. DRA

DRA agrees with TURN that in order to identify a transition period to prevent rate shock, the Commission must first determine the maximum retail rate that would be affordable. In determining affordability, DRA proposes that the Commission distinguish between the basic residential rate, which is currently capped, and the total bill for residential telephone services, which is flexibly priced. DRA further argues that because affordability of basic service may vary substantially by local region, the interim rate cap not be permanently reset until the Commission obtains geographically and demographically disaggregated baseline information about penetration rates and customer perceptions of affordable rates. DRA joins TURN in recommending a modified version of the Field Research Affordability study to assist in such a determination.26

On an interim basis pending the affordability study, DRA recommends that any increase in ILEC basic rates be allowed to rise no higher than the highest rate charged by a California ILEC, equal to SureWest's rate of $18.90. DRA calculates that increasing the AT&T rate up to the SureWest rate level would result in a 64% price rise. DRA argues that without an affordability study, however, the Commission cannot presume that SureWest's current rates are affordable. DRA also proposes that the basic rate in any pricing zone of an ILEC's service territory not exceed 150% of the lowest rate for basic service that the ILEC charges for the same service in any other pricing zone. DRA proposes this relative limitation to avoid unacceptable rate disparities between urban and rural customers due to geographic de-averaging.

DRA argues that basic rates should not be allowed to rise to the point where the Commission's goal of at least a 95% penetration rate is jeopardized. DRA argues that the 95% penetration goal should be met not just on an aggregate basis, but within separate geographic and demographic sectors. If rate increases result in a drop in penetration rates below 95%, DRA suggests that the Commission could reduce the rate or mandate other programs to boost connectivity.

DRA further proposes a maximum basic rate increase within a 12-month period of no more than $2 per month. A $2 per-month increase would represent a nearly 19% increase in AT&T's current rate. DRA argues that limiting any annual increases to this extent is an essential minimum curb on potential rate shock. DRA further argues that increases of no more than $2 per

month are more than sufficient to offset the reduced subsidy draws that the Commission authorized in D.07-09-020.27 Moreover, DRA points to AT&T's recent increases in other popular residential service options which may be offered on a bundled basis with basic service and which could easily more than offset the reduction in B-Fund subsidy on a weighted-average basis, even without an increase in the basic rate.

DRA contends that a $2 level is an essential minimum curb on potential rate shock. Setting an interim cap at $18.90 for all the URF ILECs would allow rate increases up to the highest rate for local phone service among those companies that the Commission has thus far identified as reasonable. Phasing in increases in annual increments of $2, a four-year period would be required to reach an $8 increase. DRA's proposal for a maximum increase of $2 per year would effectively result in a phase-in period of one year in order for Verizon and Frontier to reach the $18.90 cap.

DRA's proposes that the cumulative increase for AT&T be limited to $8.21, the difference between the AT&T and SureWest basic intrastate rates ($18.90 - $10.69). While AT&T proposes a somewhat similar approach, AT&T also incorporates the EUCL in its calculation, yielding a higher cumulative increase of $10.32, as discussed previously. (The EUCL for AT&T is only $4.40, but is $6.50 for SureWest.) DRA argues that there is no basis to include the EUCL in calculating the increase required to bring the AT&T rate up to the SureWest level, since the EUCL only reflects federal jurisdictional costs. The EUCL does not increase the intrastate revenues of the other URF ILECs. Thus, DRA argues there is no basis to increase AT&T intrastate revenues by raising the rate cap for AT&T to reflect any differences attributable to EUCL charges.

3.7. Sprint

Sprint argues that efforts to continue price controls are unnecessary, would be misleading, and have no practical value. Sprint argues that even if a price increase were to occur as a result of lifting the price caps, any price fluctuation would likely be small, with little effect on penetration rates for basic service. Sprint notes that although the price of basic telephone service fell between 1994 and 2007 in real inflation-adjusted terms, penetration rates for basic service changed little during the same period. Based on this past relationship between price and demand for basic service, Sprint argues that any foreseeable change in the price of basic service as a result of lifting price caps will have minimal effect of penetration rates for non-ULTS-subsidized customers, and that 95% of all households will continue to purchase local phone service.

Sprint supports the continued provision of assistance on a means-tested basis for low-income customers eligible for discounted rates through the ULTS program.

Sprint also proposes that AT&T be authorized (but not required) to gradually increase its existing price cap up to the level of SureWest's basic service rate (including the EUCL), with elimination of all price caps as of January 1, 2010. Sprint similarly proposes that Verizon, SureWest and Frontier be authorized (but not required) to effect similar price cap increases (e.g., by the same percentage as authorized for AT&T) and to consider price caps eliminated on the same dates.

24 The EUCL charge is a federally mandated charge reflects the FCC determination of the interstate portion of non-traffic-sensitive costs that should be collected from the basic exchange subscriber.

25 AT&T's calculations used a starting rate of $10.69, which was the rate in effect at the time its comments were filed. Subsequent to filing comments, AT&T's rates have changed due to the 2.36% increase allowed for 2008 and a small change to their EUCL. The difference between their rate plus the EUCL and the SureWest rate and EUCL is now $10.06, which would result in $5.03 per-month increases in 2009 and again in 2010.

26 TURN and DRA propose that the earlier Field Research Studies be modified (1) to include more geographically granular data than were collected in prior surveys (to detect the effects of any geographically deaveraged prices and to investigate what is happening specifically in designated high-cost areas), and (2) to cover all four URF ILEC territories and customers of all service providers. (See DRA Opening Comments on the PD at 6.)

27 DRA calculates that the authorized reduction in AT&T's draw from the B-Fund as of January 1, 2008 could be offset by an increase of $2.08 per line, and the further reduction as of January 1, 2009 could be offset by an increase of $0.76 per line. (See DRA Comments at 29-30.)

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