III. Applicable Standards

C. The Consensus Costing Principles

During the first years of the Commission's efforts to cost "basic network functions," the precursors to UNEs, the Commission adopted a set of "Consensus Costing Principles" (CCPs) that had been negotiated and agreed to by AT&T, MCI and SBC-CA and others for use in those early cost proceedings.²² (See D.95-12-016, Appendix C.) According to JA, the CCPs in large part foreshadowed the FCC's TELRIC principles and are largely based on the concept of determining incremental costs that reflect the entire quantity of the output provided. (JA, 10/18/02, p. 4.) Additional critical concepts incorporated in the CCPs include:

· Principle No. 1: Long run implies a period long enough that all costs are variable.

· Principle No. 2: Cost causation is a key concept in incremental costing.

· Principle No. 3: The increment being studied shall be the entire quantity of the service provided, not some small increase in demand.

· Principle No. 6: Technology used in a long run incremental cost study should be the least-cost, most efficient technology that is currently available for purchase. This principle assumes that a TSLRIC analysis should be based on the existing or planned location of switching and outside plant facilities using the least-cost, most efficient technology.

· Principle No. 7: Costs shall be forward looking.

D. The TELRIC Standard

The Telecommunications Act of 1996 (the Act) requires incumbent local exchange carriers (ILECs) such as SBC-CA to interconnect with any requesting telecommunications carrier at rates, terms and conditions that are just, reasonable, and nondiscriminatory, and in accordance with Section 252 of the Act. (Section 251(c)(2).) Section 252(d) of the Act sets the pricing standard for interconnection and network element charges and states that when state commissions determine a just and reasonable rate for purposes of Section 251(c)(2), the rate shall be "based on the cost (determined without reference to a rate of return or other rate-based proceeding) of providing the interconnection or network element," it shall be nondiscriminatory, and it may include a reasonable profit.

Following the passage of the Act, the FCC set forth the applicable costing standard to implement the Act in its August 1996 First Report and Order. Federal regulations provide that state commissions shall comply with the FCC's forward-looking economic cost-based pricing methodology when setting UNE rates for incumbent LECs such as SBC-CA. (47 C.F.R. Sec. 51.503(b)(1).) Generally, the FCC's forward-looking economic cost of a UNE equals the sum of (1) the TELRIC of the element, and 2) a reasonable allocation of forward-looking common costs. (47 C.F.R. Sec. 51.505(a).) The TELRIC of an element is "the forward-looking cost over the long run of the total quantity of the facilities and functions that are directly attributable to, or reasonably identifiable as incremental to, such element, calculated taking as a given the incumbent LEC's provision of other elements." (47 C.F.R. Sec. 51.505(b).) In providing further guidance on the concept of "forward-looking economic cost," the FCC specifies that the TELRIC of an element "should be measured based on the use of the most efficient telecommunications technology currently available and the lowest cost network configuration, given the existing location of the incumbent LEC's wire centers." (47 C.F.R. Sec. 51.505(b)(1).)

Finally, the FCC regulations specify that "embedded costs" and "retail costs" shall not be considered when calculating the forward-looking economic cost of a UNE. (47 C.F.R. Sec. 51.505(d).) "Embedded costs" are defined as "costs that the incumbent LEC incurred in the past that are recorded in the incumbent LEC's books of accounts." (47 C.F.R. 51.505(d)(1).) "Retail costs include the costs of marketing, billing, collection, and other costs associated with offering retail telecommunications services to subscribers who are not telecommunications carriers..." (47 C.F.R. 51.505(d)(2).) We note, however, that there is a substantial difference between "current costs" - the costs that a company incurs today, and "embedded costs" - the costs that are the amalgam of investments made over many years. Current costs can provide a strong basis for determining forward looking costs; embedded costs do not.

E. Supreme Court Review of TELRIC Standard

The FCC's TELRIC methodology has been upheld by the U.S. Supreme Court following challenges to the methodology from ILECs. (Verizon Communications Inc. v. FCC, 122 S.Ct. 1646 (2002).) ILECs argued that the TELRIC methodology resulted in costs that are too low because it is based on a "hypothetical" and "most efficient" network rather than the incumbent's actual network. The Supreme Court rejected this argument and stated that:

As for an embedded-cost methodology, the problem with a method that relies in any part on historical cost, the cost the incumbents say they actually incur in leasing network elements, is that it will pass on to lessees the difference between most-efficient cost and embedded cost. Any such cost difference is inefficiency, whether caused by poor management resulting in higher operating costs or poor investment strategies that have inflated capital and depreciation. If leased elements were priced according to embedded costs, the incumbents could pass these inefficiencies to competitors in need of their wholesale elements, and to that extent defeat the competitive purpose of forcing efficient choices on all carriers whether incumbents or entrants. The upshot would be higher retail prices consumers would have to pay. (Verizon, 122 S.Ct. at 1673.) (Citations and footnotes omitted.)

F. Recent Updates to TELRIC

The FCC's recent Triennial Review Order (TRO) provided additional clarification on depreciation lives and cost of capital, which are key inputs in a TELRIC modeling exercise. We address the specific clarifications from the TRO in the sections below that address depreciation and cost of capital.

G. Commission Cost Modeling Criteria

In a June 2002 Scoping Memo, the Assigned Commissioner and Administrative Law Judge established the criteria for any cost models or studies filed in this proceeding. The Scoping Memo clarified that any cost models or studies must allow parties to:

1. Reasonably understand how costs are derived by:

a. Providing access to all interested parties to the model and all underlying data, formulae, computations, software, engineering assumptions, and outputs; and

b. Allowing interested parties to examine and modify the critical assumptions and engineering principles.

2. Generally replicate the cost model or cost study calculations; and

3. Propose changes in inputs and assumptions in order to modify the costs produced.²³

In Section V.C below, we shall discuss whether the models filed adhered to these criteria.

H. Burden of Proof

As part of its implementation of the Act, the FCC adopted regulations that provide that the ILEC bears the burden of proving that the UNE rates it proposes do not exceed forward-looking economic cost. (47 C.F.R. 51.505(e).) In adopting these regulations, the FCC recognized there was asymmetric access to cost data because ILECs have greater access to cost information necessary to calculate incremental costs of providing UNEs. Therefore, in this proceeding, SBC-CA has the burden to demonstrate that the rates it proposes do not exceed forward-looking economic cost for each UNE.

The other parties that have presented proposals for TELRIC costs or inputs to cost models bear the burden of persuading the Commission that their proposals are reasonable given the FCC's TELRIC standards and the Commission's CCPs.

In comments on the Proposed Decision, SBC-CA contends the Commission has imposed an impossible standard on SBC-CA by requiring it to prove its network is not inefficient. SBC-CA maintains that when the FCC noted incumbent LECs have greater access to cost data, it was concerned with the accuracy of the data and not whether an ILEC could prove its network was perfectly efficient. We disagree with SBC-CA that we have misapplied the burden of proof. If SBC-CA uses its current network as a proxy for an efficient and forward-looking network, it must prove that the costs it proposes are not inefficient and that it is reasonable to conclude that they are forward-looking.

²² The CCPs were developed to support the Total Service Long Run Incremental Cost (TSLRIC) methodology, which derives costs based on services offered rather than network elements. The principles are also considered applicable to TELRIC analyses. ²³ Scoping Memo for Consolidated 2001/2002 UNE Reexamination for Pacific Bell Telephone Company, 6/12/02, p. 16.