X. Z-Factor Process

A. RTC

1. General

RTC proposes that the Commission modify the Z-factor criteria to narrow the scope of exogenous events that qualify for recovery. Specifically, RTC proposes that the Z-factor criteria be changed to the following.

a. Specific existing items already identified by the Commission such as the future extended area service (EAS) transition authorized by D.96-12-074.

b. Z-factor items that are now being implemented such as the Interstate Universal Service Fund, Payphone Deregulation, and Ordering, Billing and Collection Equal Measure, and Fiber to the Curb Adjustments.

c. Adjustments for impacts of jurisdictional cost shifts.

d. Recovery of Commission mandated cost changes when authorized by a Commission decision.

RTC stated that, for Pacific and Verizon in D.98-10-026, the Commission authorized recovery for limited future exogenous factors and eliminated recovery of new ones except for specified adjustments already identified in other Commission proceedings. RTC cited the following language from D.98-10-026.

"elimination of new Z-factor recovery shifts risks to shareholders, is consistent with our removing the upper and lower bounds on earnings, reduces asymmetry, simplifies the regulatory process, and is compatible with our promotion of competition, as we continue through this transitional period to a fully competitive market."

RTC believes its proposal is consistent with the above language.

2. PBOP

RTC states that, at the time D.92-12-015 was issued, RTC was not a NRF company. Accordingly, RTC followed those portions of D.92-12-015 applicable to cost-of-service regulated utilities. D.92-12-015 required cost-of-service utilities to true-up their PBOP expenses as part of their next general rate case (GRC). RTC's PBOP expenses were trued up, and the switch of PBOP expenses to accrual recovery was authorized in the next GRC (D.96-12-074). Since D.96-12-074, there have been no Z-factor adjustments for PBOP or any other expenses that were the basis of RTC's NRF start-up revenue requirement set in D.96-12-074.

RTC states that the fact that actual accruals are different from those adopted in D.96-12-074 does not justify ORA's proposed revenue reduction. PBOP is no different from any other element of the results of operations forecasted in the GRC. Furthermore, ORA's proposed refund constitutes prohibited retroactive ratemaking. Additionally, if the Commission were to adjust rates prospectively for this expense, it should also do so for all other elements involved in the revenue requirement adopted in D.96-12-074.

RTC alleges that the requirements of D.92-12-015 and D.97-04-043 for NRF companies apply only to Pacific and Verizon. Since RTC has never requested Z-factor recovery of PBOP, these requirements do not apply to RTC.

RTC represents that it has been placing funds in the PBOP trust. It made contributions of $129,896 in 1998 and $57,801 in 1999. The lower amount in 1999 was due to the fact that the trust earned in excess of what would be expected based on the forecast 1996 GRC test year PBOP expense of $98,600. Additionally, RTC says that it has been unable to place funds in the trust on a year-by-year basis because of Internal Revenue Code requirements. Accordingly, RTC has invested the additional PBOP funds until such time as they can be contributed to the trust. The funds were not diverted.

B. ORA

1. General

ORA does not oppose eliminating new Z-factor adjustments, establishing an LE mechanism, and allowing recovery for those items that have been expressly ordered by the Commission for implementation in 2000 and thereafter until they expire or the Commission orders otherwise. However, ORA opposes recovery of changes in EAS payments because such recovery is not currently a Z-factor. ORA believes that any recovery of EAS payments must be considered as an LE factor adjustment. ORA does not oppose LE factor recovery of RTC's payment of the auditor's costs of the non-regulated operations audit.

2. PBOP

ORA proposes that accrual rate recovery for PBOP be eliminated for RTC through a permanent annual revenue reduction of $98,600. In addition, ORA recommends a one time refund of $165,904 to ratepayers for PBOP funds that were not deposited in an independent qualified PBOP trust as required by the Commission.

ORA states that RTC did not receive Commission authorization to fund PBOP accruals until its 1996 GRC. In the 1996 GRC decision, D.96-12-074, the Commission set RTC's initial revenue requirement for PBOP accruals.

ORA states that in D.92-12-015 the Commission authorized those utilities subject to cost-of-service regulation to recover PBOP costs associated with the switch to accrual accounting and paid into independent trusts to the extent that they, among other things, establish independent PBOP trusts and make tax-deductible contributions which do not need to be grossed up by a net-to-gross multipliers. The decision also provided that NRF utilities could recover, through Z-factor filings, the amount required to be accrued that year to cover future costs less pay-as-you-go costs. Additionally, NRF utilities could recover only the amount actually put into a PBOP trust. Z-factor treatment of PBOP would be trued up in subsequent price cap filings. ORA represents that these requirements were reaffirmed in D.97-04-043.

ORA claims that RTC has not made adequate tax-deductible PBOP contributions, has not recovered PBOP costs through Z-factor filings and has not trued up PBOP costs in its annual price cap filings. Since RTC is a NRF utility and RTC has not been exempted from the requirements of D.92-12-015 and D.97-04-043, RTC is in violation of item. Therefore, the revenue requirement for PBOP should be removed from RTC's authorized revenues. This would be a permanent, reduction of $98,600 in annual revenues.

ORA asserts that RTC did not make PBOP contributions to the trusts in 1997 and 1999. This resulted in over-collected revenues of $165,904. ORA recommends that these funds be refunded to ratepayers.

C. Discussion

3. General

RTC and ORA agree on eliminating new Z-factor adjustments, establishing an LE factor mechanism and allowing recovery for those items that have been expressly ordered by the Commission for implementation in 2000 and thereafter. Additionally, there is no opposition to LE factor recovery of the non-regulated operations audit costs. However, ORA opposes RTC's proposal to allow recovery of specific items not already identified by the Commission for potential Z-factor treatment.

In D.98-10-026, the Commission eliminated consideration of new Z-factor adjustments. This was done in order to shift more of the risk of cost changes to shareholders and to eliminate the asymmetry with regard to competitors. Additionally, elimination is consistent with the suspension of sharing and simplifies the regulatory process.

The Commission allowed continued consideration of Z-factors then under review and allowed existing Z-factor adjustments to finish implementation. This was done because prior Z-factor treatment has increased rates in some instances, with offsetting decreases expected in later years.

The Commission implemented a streamlined advice letter process that allows Pacific and Verizon to request recovery of cost increases or decreases resulting from (1) matters mandated by the Commission and (2) changes in total intrastate cost recovery resulting from changes between federal and state jurisdictions. This process, called the LE factor mechanism, was adopted because the two allowed exceptions remain potentially significant exogenous events outside of management control. Rate changes for Commission-mandated cost changes are limited to those costs for which LE factor adjustment is authorized in the underlying Commission decision.

We see nothing unique about RTC that would justify treating it differently. Therefore, we will eliminate Z-factor recovery immediately. We will allow further consideration of Z-factors currently before us. We will also finish implementation of those Z-factors now being implemented. We will also allow LE recovery of the non-regulated operations audit costs.

In D.00-11-039 in A.99-08-043, the Commission addressed EAS replacement funding. The Commission ended Pacific Bell's payments to RTC for EAS and authorized interim recovery from the California High Cost Fund - B. The Commission also instructed the ALJ assigned to that proceeding to issue an order instituting investigation (OII) into RTC's revenue requirement to determine the amount to be recovered and whether recovery should be from RTC's stockholders, ratepayers or both. Given this development, there is no need to address EAS in this proceeding.

4. PBOP

In D.92-12-015, the Commission stated the following about PBOP:

"We must consider whether NRF utilities should make a one-time Z-factor filing or annual Z-factor filing to reflect PBOP costs. We note that pay-as-you-go costs are projected to increase over time. Furthermore, if we retained pay-as-you-go accounting, any increase in pay-as-you-go costs would not be entitled to Z-factor treatment. Therefore, the NRF utilities' additional recovery for PBOP costs through the Z-factor should be limited to the difference between what is required by accrual accounting and what their pay-as-you-go costs otherwise would have been. It appears that the difference between the amount required for PBOP costs under accrual accounting and the amount required under pay-as-you-go accounting may decrease over time. Indeed, we have earlier noted evidence that the cost of an accrual funded plan would eventually be less expensive than a pay-as-you-go plan. Therefore, we should not authorize NRF utilities to recover as a permanent Z-factor the increase in rates for PBOP necessary during the first year. If we did that, the NRF utilities might realize a windfall. Accordingly, it appears that yearly adjustments to the Z-factor recovery for PBOP costs will be required. Our decision today will order such annual adjustments."

Ordering Paragraph 2, 3 and 8 of D.92-12-015 provide:

"2. Regulated utilities under traditional cost-of-service ratemaking and the new regulatory framework (NRF) shall be authorized to recover their PBOP costs associated with the adoption of the Statement and actually paid to independent trusts to the extent that the utilities:

"a. Establish and use independent trusts for the receipt, investment, administration, and disposition of PBOP.

"b. Make tax-deductible contributions which do not need to be grossed up by a net-to-gross multiplier. Earnings to the trust may be tax-free or taxable to the trust or employees.

"c. Use PBOP trust funds for only PBOP.

"d. Incur PBOP costs that the Commission finds are reasonable and necessary to meet funding requirements based on fair actuarial assumptions, contributions, and investments.

"e. Do not use PBOP to enhance pension benefits.

"f. Recovery of tax-deductible contributions in any given year shall not increase over the prior year's PBOP expense recovery by more than 1% of the utilities total prior year's operating revenue. For those utilities under NRF, the 1% limit shall be applied to the net changes in their annual price cap revenue base.

"g. The utilities shall, to the extent allowed by the Internal Revenue Service (IRS) and employee unions, apply surplus pension assets (as defined by the IRS) to fund their PBOP expense.

"3. To the extent that PBOP trust assets cannot or are not used for PBOP obligations, then those assets shall be returned to ratepayers as allowable by law. Utility rates are hereafter made subject to refund, but only to the extent necessary to allow such a return to ratepayers of any PBOP assets that cannot be used for PBOP expenses or that have been used for other purposes.

"8. In addition to the requirements of Ordering Paragraph 2, NRF utilities shall recover through annual Z-factor filings only the amount required to be accrued that year to cover future PBOP payments, minus their pay-as-you-go costs. Furthermore, the Z-factor should only recover this amount to the extent it is actually put into a trust. The Z-factor treatment of PBOP costs shall be trued up in each subsequent years' Z-factor filings to ensure compliance with these requirements."

When we authorized the switch to accrual accounting for PBOP, we anticipated an initial revenue requirement increase followed by decreases over time. For Pacific and Verizon, we established the revenue requirement increase as a Z-factor in D.92-12-015. We expected annual Z-factor adjustments in the PBOP as the revenue requirement decreased. Finally, in D.98-10-026, we eliminated the remaining PBOP revenue requirement and eliminated Z-factor recovery of PBOP.

In RTC's case, in D.96-12-074, we trued up PBOP costs prior to 1997 and set an initial PBOP revenue requirement. We also adopted for RTC the basic NRF as it had been adopted for Pacific and Verizon. Therefore, the NRF PBOP requirements placed on Pacific and Verizon apply to RTC. As a result, decreases in the PBOP revenue requirement for RTC should have been addressed in their Z-factor filings. Additionally, since we eliminated the PBOP revenue requirement for Pacific and Verizon in D.98-10-026, we should do so for RTC in this proceeding.

RTC argues that if other expenses reflected in its GRC in D.96-12-074 are adjusted, all expenses should be adjusted. In general we would agree. When we adopt a revenue requirement in a GRC, it is for the purpose of setting reasonable rates. It is not a rigid budget that the utility must follow in the test-year or succeeding years. However, there are exceptions. In Conclusion of Law 7 in D.92-12-015, we said:

"the utilities under traditional ratemaking and the telecommunications utilities under the NRF process should recover their PBOP costs in rates to the extent that they are able to make contributions to tax-deductible plans."

Therefore, PBOP is such an exception.

RTC and ORA agree that the PBOP revenue requirement established in D.96-12-074 for RTC is $98,600. Therefore, consistent with our treatment of Pacific and Verizon, we will reduce RTC's annual revenue requirement by $98,600. RTC's rates shall be adjusted accordingly.

RTC states that in 1998 and 1999 it made PBOP contributions of $129,896 and $57,801 respectively. RTC made no contributions in 1997. RTC states that those PBOP funds not invested in the trust because of Internal Revenue Code requirements, are invested in income producing vehicles until such time as RTC can place them in the PBOP trust. RTC also states that it would need less than $300,000 in the PBOP trust to satisfy the requirement that all of the PBOP revenue requirement must be invested in the PBOP trust. RTC states that the current balance is over $1.2 million. We conclude, therefore, that the PBOP trust is well funded and that RTC has not put all of the PBOP revenue requirements for 1997, 1998 and 1999 in the PBOP trust. We do not conclude, however, that RTC has diverted the excess revenue requirement funds to other uses. As a result, we will require RTC to file an advice letter to make a Z-factor adjustment to return to ratepayers the 1997 through 1999 PBOP revenues not invested in the PBOP trust. We shall also require RTC to file an advice letter to refund PBOP revenues not placed in the PBOP trust in 2000 and to reduce the 2001 annual revenue requirement by $98,600 as a surcredit. The $98,600 annual revenue reduction will be permanent. Once the funds have been returned to ratepayers and the $98,600 revenue reduction has been implemented, the Z-factor adjustment shall be eliminated and no further Z-factor adjustments for PBOP shall be filed.

RTC states that the excess POBP revenue requirement funds have been invested. Therefore, in addition to the funds themselves, the investment proceeds earned by these excess funds, shall also be returned to ratepayers.