XVI. Vestiges of Rate-of-Return Regulation, Including the Calculation of Rates of Return and Revenue Sharing

This section discusses many vestiges of earnings regulation that fall within the scope of Phase 1 of this proceeding, but are not mentioned elsewhere in this decision. These vestiges of earnings regulation include requirements concerning the calculation of the price cap index and earnings sharing.

The most controversial issue in this section concerns Yellow Pages directory earnings. The major point of contention over this issue is found in parties' interpretation of Public Utilities Code § 728.2(a):

Except as provided in subdivision (b), the commission shall have no jurisdiction or control over classified telephone directories or commercial advertising included as part of the corporation's alphabetical telephone directories, including the charges for and the form and content of such advertising, except that the commission shall investigate and consider revenues and expenses with regard to the acceptance and publication of such advertising for purposes of establishing rates for other services offered by telephone corporations.

We review and assess parties' interpretations of this statute below.

A. Position of Parties

AT&T proposes a "permanent elimination of price cap and earnings sharing mechanisms, imputation of yellow pages directory earnings, and all other earnings-related requirements."⁸²⁵ It argues that earnings regulation generally "distorts operating and investment decisions."⁸²⁶ According to AT&T, earnings regulation "affects the financial expectations that are an integral part of such decisions, introducing uncertainty into present and future revenue streams. As a result, it can cause companies to delay or reject otherwise cost-effective investments. Earnings regulation thus fails to provide the correct economic incentives in a competitive telecommunications marketplace."⁸²⁷

As regards reporting requirements, AT&T asserts that "it makes no sense to eliminate earnings regulation but continue to impose earnings reporting requirements that are meaningful only in a framework that regulates earnings."⁸²⁸ AT&T adds that imposing earnings requirements only on certain carriers "perpetuates asymmetric regulation, contrary to the Commission's objective of a uniform regulatory framework. . . . Indeed, a `financial scorecard' that is based on Commission-imposed earnings conventions applied selectively to some carriers and not to others would be neither valid nor useful."⁸²⁹ AT&T maintains that it would be better to eliminate earnings rules so that all companies would have the same incentives to reduce cost, introduce new services, and invest.⁸³⁰

With respect to Yellow Page directory earnings in particular, AT&T insists that Public Utilities Code § 728.2(b)(1) "applies only under specific, limited circumstances that have never existed."⁸³¹ The ILEC provides the following statutory analysis:

Section 728.2(b) . . . would only apply if the Commission determined that "federal action would impair its ability to investigate and consider revenues and expenses with regard to the acceptance and publication of telephone directory advertising for the purpose of establishing rates for other services offered by any telephone corporation. . . ." The Commission has never had any reason to make such a determination. While § 728.2(a) states in part that the Commission "shall investigate and consider revenues and expenses with regard to the acceptance and publication of such advertising for purposes of establishing rates for other services offered by telephone corporations," the Commission discontinued establishing rates for AT&T California based on a revenue requirement over 16 years ago, after it adopted NRF and a start-up revenue adjustment.⁸³²

AT&T adds that "earnings measures that include results from long-unregulated yellow pages advertising services provide no useful information about earnings from regulated telecommunications services. There is no longer any regulatory purpose served by imputing yellow pages directory earnings."⁸³³ Cox agrees with AT&T's position on earnings regulation and Yellow Page earnings more specifically.⁸³⁴

Verizon proposes that earnings regulation, including California-specific "ratemaking" adjustments and the NRF earnings-sharing mechanism, be permanently ended.⁸³⁵ It states that the Commission should no longer monitor earnings beyond any FCC ARMIS reporting requirements.⁸³⁶ Verizon also asserts that the Commission "will have no need to monitor or impute directory revenues and expenses pursuant to Public Utilities Code section 728.2."⁸³⁷

Regarding earnings regulation in general, Verizon states that "it is a fundamental concept of sound economics that regulated companies will not make investments if they believe that the regulator will expropriate the benefits of those investments. . . . Continuing earnings regulation, therefore, harms consumers by denying them the benefits of full investment."⁸³⁸ Verizon adds that ending earnings regulation "would fulfill the policy direction charted by the Commission"⁸³⁹ in a prior decision that held that we "expect permanent elimination as part of the evolution of our regulation in response to continued changes in the market."⁸⁴⁰ We explained that "permanent elimination will remove regulatory risk, and provide desirable certainty to the market."⁸⁴¹

Verizon opposes monitoring requirements too. It states that these requirements serve no useful purpose in a market driven industry.⁸⁴² Because such scrutiny is not applied to CLECs or to other intermodel competitors, Verizon argues it creates unnecessary burdens, litigation, deters investment, and is inconsistent with the goal of competitive and technological neutrality.⁸⁴³

Verizon further contends that Yellow Page earnings should not be reported. It argues that Public Utilities Code § 728.2(b)(1) "applies only when the Commission is `establishing rates' for the incumbents. The Commission is not establishing rates in URF, so the code section does not apply."⁸⁴⁴

Frontier and SureWest assert that "all carriers should be unconstrained by earnings regulation, whether by earnings sharing or otherwise."⁸⁴⁵ They also argue that "there is no justification for continuing to use unregulated directory advertising revenues to `support' ILEC telephone services."⁸⁴⁶

With regards to earnings regulation, Frontier and SureWest contend that earnings regulation is "inappropriate and counterproductive" in a competitive marketplace: "In a competitive environment, carriers will naturally invest in the provision of services that offer a good return. Those services will offer a good return because of customer demand. . . . [A]ll competitors can direct investments to services that they believe are in greatest demand and will appeal to the maximum number of customers."⁸⁴⁷

Addressing Yellow Page earnings reporting, Frontier and Surewest argue that director advertising is a "highly competitive business":

There are many competitive directories, and white pages directories lost their copyright protection many years ago thereby eliminating a barrier to entry for competing directory providers. In addition, all directories compete with many other forms of advertising, including the internet. To compound this competitive situation, the services that directory advertising historically have been used to support are now competitive as well.

The mid-size ILECs conclude, therefore, that there "is simply no justification for continuing to use directory advertising revenues to subsidize any service or product, and directory advertising revenues should be decoupled from other intrastate revenues."⁸⁴⁸

DRA recommends that the Commission "no longer require California-specific adjustments as part of earnings monitoring beyond those required to implement California statutes and regulations."⁸⁴⁹ DRA cites "simple `overlays' to standardized Uniform System of Accounts (USOA) reporting to identify the effect on earnings of the incumbents' Yellow Pages . . . operations" as an example of monitoring for a statutory requirement. It further urges the Commission to "develop details of any California-specific earnings adjustments either in implementation workshops or in a later phase of this proceeding."⁸⁵⁰

Regarding Yellow Page earning monitoring more specifically, DRA argues that "[t]he coupling of yellow pages directory earnings and rates . . . is set forth in statute, and the CPUC cannot eliminate that coupling":

The CPUC is statutorily required to consider yellow pages revenues and expenses in the setting of rates for "other services" the ILECs offer. At the same time, to the extent the CPUC chooses not to establish rates for services it deems fully competitive - as it has done with services presently in Category III under the New Regulatory Framework - then the CPUC would not have to consider yellow pages revenues in connection with those rates.

DRA concludes that "so long as the CPUC sets rates for any ILEC services, it must consider yellow pages revenues and expenses in the setting of those ILEC rates."⁸⁵¹

Specific statutory considerations notwithstanding, DRA adds that "`decoupling' could result in harm to ratepayers by distorting the picture of the profitability that the Respondents derive from activities that are integrally related to their local exchange line of business."⁸⁵² It argues that since the ILECs "dominate the directory publishing industry,"⁸⁵³ their directories are perceived to be the "official" white and yellow pages,⁸⁵⁴ and as such "[t]he CPUC has consistently recognized the need to include directory publishing revenues and profits within the reported intrastate earnings of the major ILECs," the reporting practice should not change.⁸⁵⁵ DRA adds that "[a] substantial body of regulatory and judicial decisions have concluded that directory advertising income is properly considered attributable to the intrastate regulated telephone company's operations."⁸⁵⁶

TURN proposes that "for this transitional period, earnings regulation can be eliminated," but, consistent with DRA's recommendation, "ILECs should continue to report intrastate earnings according to Commission requirements."⁸⁵⁷ TURN includes Yellow Pages earnings in its list of items that should continue to be reported.⁸⁵⁸ It argues that the Public Utilities Code prevents "decoupling" of Yellow Page revenue: "The Commission is obligated to follow the requirements of P.U. Code § 728(2)(b)(1). . . . The Commission does not have the authority to alter this requirement."⁸⁵⁹ TURN also echoes DRA's assertion that "`decoupling' could result in harm to ratepayers by distorting the picture of the profitability that the Respondents derive from activities that are integrally related to their local exchange line of business.'"⁸⁶⁰

DOD/FEA states that its proposal "would essentially eliminate earnings regulation."⁸⁶¹ While it would institute a revenue cap (described in Section VII), DOD/FEA would allow ILECs "to file for an increase to [their] basic local service revenue cap if it believes a significant revenue shortfall exists for these services."⁸⁶² This filing would "be required to reflect an imputation of Yellow Page revenues."⁸⁶³

Other parties do not specifically address earnings regulation or Yellow Page revenues.

B. Discussion: Vestiges of Earnings Regulation No Longer Serve the Public Interest

All commenting parties support the elimination of most PUC earnings regulation. Moreover, given our decision today, there is no longer a need for the NRF regulatory apparatus of price caps, annual price cap filings, "productivity factors," and "sharing of revenues" that are included in the price cap calculations.

ILECs are correct to argue that earnings regulation, like earnings sharing, distorts investment decisions. Firms factor in the risk of future regulation and its potential appropriation of gains in their investment decisions. While monitoring of Yellow Pages revenues and other regulatory accounts and adjustments may seem harmless, it is indeed a signal to firms that they should still factor a risk into their calculations. We also should take into account the need for monitoring. Here there is no justifiable need for monitoring, because of the competitive environment that exists today in telecommunications. Regular reports of "regulated" earnings can only distort firms' decisions and conflict with the reports required by financial markets.

Market conditions also inform our interpretation of Public Utilities Code § 728.2(a). We observe that directory listings service for telephony has been long been de-regulated. This listing service is a competitive business that has significant competition not just with other white and yellow page books, but with other forms of advertising and, most significantly, the Internet. In light of this marketplace, we disagree with DRA's argument that only the ILEC's directory listing books are considered "official" books.

Moreover, as Frontier and SureWest point out, "the services that directory advertising historically have been used to support are now competitive as well."⁸⁶⁴ So even if statute did require the reporting of Yellow Page earnings, this requirement nevertheless no longer pertains to today's marketplace. The statute applies only when the Commission is establishing rates: The law states "that the commission shall investigate and consider revenues and expenses with regard to the acceptance and publication of such advertising for purposes of establishing rates for other services offered by telephone corporations" (italics added).⁸⁶⁵ As this Commission does not establish rates for telephone services, there is no requirement to consider this information further. We caution against putting form over substance, particularly when it disadvantages one market player over another in an unfair manner.

Therefore, we find it reasonable to end all the vestiges of the prior NRF and rate of return regulation. We eliminate price caps, the annual price cap filing, the productivity factor, and all residual elements of rate of return regulation, including the calculation of "shareable" earnings.

In addition, we end the reporting of Yellow Page revenues, because the reporting is not required by statute and serves no useful purpose. As discussed in Section XIV, we have determined to bring California accounting policies in line with standard accounting practices. Including Yellow Page "adjustments" would cause California accounts to depart from the standard accounting practices we pledged to use.

⁸²⁵ Pacific Bell Opening Brief at 54-55.

⁸²⁶ Id. at 54 (citing Harris Opening Comments at 49-51; Rulemaking on the Commission's Own Motion into the Third Triennial Review of the Regulatory Framework Adopted in Decision 89-10-031 for GTE California Incorporated and Pacific Bell, 98-10-026, 82 CPUC 2d 325, 355 (1998)).

⁸²⁷ Id. at 54 (citing Harris Opening Comments at 49-51; Rulemaking on the Commission's Own Motion into the Third Triennial Review of the Regulatory Framework Adopted in Decision 89-10-031 for GTE California Incorporated and Pacific Bell, 98-10-026, 82 CPUC 2d 325, 355 (1998)).

⁸²⁸ Id.

⁸²⁹ Id.

⁸³⁰ Id. at 54 (citing Taylor Opening Comments at 28-29).

⁸³¹ AT&T Reply Brief at 55.

⁸³² Id. at 55.

⁸³³ Id.

⁸³⁴ Cox Reply Brief at 14 (citing Pacific Bell Opening Brief at 75).

⁸³⁵ Verizon Opening Brief at 4.

⁸³⁶ Verizon Opening Brief at 4.

⁸³⁷ Id. at 18.

⁸³⁸ Id. at 30 (citing Aron Opening Comments at ¶¶ 201-206; Aron Reply Comments at ¶ 132).

⁸³⁹ Id.

⁸⁴⁰ Rulemaking on the Commission's Own Motion into the Third Triennial Review of the Regulatory Framework Adopted in Decision 89-10-031 for GTE California Incorporated and Pacific Bell, 98-10-026, 82 CPUC 2d 325 (1998), 1998 Cal. PUC LEXIS 669, 47.

⁸⁴¹ Rulemaking on the Commission's Own Motion into the Third Triennial Review of the Regulatory Framework Adopted in Decision 89-10-031 for GTE California Incorporated and Pacific Bell, 98-10-026, 82 CPUC 2d 325 (1998), 1998 Cal. PUC LEXIS 669, 47.

⁸⁴² Verizon Opening Brief at 30.

⁸⁴³ Id. at 29-31.

⁸⁴⁴ Verizon Reply Brief at 19.

⁸⁴⁵ Citizens Opening Brief at 23; SureWest Opening Brief at 27.

⁸⁴⁶ Citizens Opening Brief at 25; SureWest Opening Brief at 28.

⁸⁴⁷ Citizens Opening Brief at 23-24; SureWest Opening Brief at 27.

⁸⁴⁸ Citizens Opening Brief at 25; SureWest Opening Brief at 28-29.

⁸⁴⁹ DRA Opening Brief at 10.

⁸⁵⁰ Id. at 11.

⁸⁵¹ DRA Reply Brief at 26-27.

⁸⁵² ORA Opening Comments at 48.

⁸⁵³ Id. at 49.

⁸⁵⁴ Id. at 50.

⁸⁵⁵ Id. at 50-51 (citing Interim Opinion Regarding Phase I Issues, D.02-10-020, 2002 Cal. PUC LEXIS 647, mimeo at 21-30).

⁸⁵⁶ Id. at. 50-51 (citing a number of other states' regulatory decisions).

⁸⁵⁷ TURN Opening Brief at 40.

⁸⁵⁸ Id. at 40-41.

⁸⁵⁹ Id.

⁸⁶⁰ Id. at 41 (citing DRA Opening Comments at 49).

⁸⁶¹ DOD/FEA Opening Brief at 13.

⁸⁶² Id.

⁸⁶³ Id.

⁸⁶⁴ Citizens Opening Brief at 25; SureWest Opening Brief at 28-29.

⁸⁶⁵ Cal. Pub. Util. Code § 728.2(a).