By this decision, we adopt essential preliminary reforms to the California High Cost Fund-B (CHCF-B or B-Fund) program. Pursuant to Public Utilities Code § 739.3, the CHCF-B program was established in 1996 as part of a broader policy framework to ensure that universal telephone service goals are met throughout California. The CHCF-B program was designed to support "universal service" goals by ensuring that basic telephone service remains affordable in high cost areas within the service territories of the major incumbent local exchange carriers (ILECs).

As a result of the preliminary reforms implemented in this order, we estimate that the B-Fund (currently at $434.6 million) will decline by approximately $315.4 million by July 1, 2009, representing a 74% reduction in subsidy expenditures. As explained below, we thus reduce the B-Fund retail surcharge from 1.3% to 0.5% effective January 1, 2008. Also, in the next phase of this proceeding, we expect to institute further reforms designed to target any remaining price supports in a more efficient manner consistent with our universal service obligations. In adopting the reforms herein, we uphold our obligation to meet universal service goals while recognizing the dramatic changes in the competitive landscape of voice services that have occurred over the past decade. Our adopted reforms are consistent with the uniform regulatory framework (URF) for the telecommunications industry that we initiated in D.06-08-030 in which the Commission found that:

"the ubiquity of the FCC unbundling policies limits the market power of AT&T, Verizon, SureWest, and Frontier. Cross-platform competition, particularly that from wireless and VoIP technologies, provides an additional check that reduces market power of each carrier. Also Verizon and SureWest have demonstrated the presence of competitors throughout their entire service territories. Thus, a geographically specific analysis of policy and competitors makes clear that the ILECs no longer possess market power."¹

We are also guided by governing federal and state statutes regarding universal service principles as well as legislative and Commission mandates for review of the B-Fund.

Under the B-Fund program, a Carrier of Last Resort (COLR) must offer basic residential service to all customers within a designated service area, and receives funding to subsidize affordable basic rates in high cost areas. Prior to the B-Fund program, a system based on implicit cross-subsidies had kept basic rates affordable.² By replacing these implicit cross-subsidies with a separate explicit subsidy fund, the CHCF-B was designed to facilitate competitive cost-based pricing for services other than basic service, while supporting the affordability of basic service. Thus, historic pricing structures that would price business services higher than comparable residential services or price intrastate long distance service higher than cost could be reduced or eliminated with the creation of the B-Fund.

The reforms adopted herein address the significant market and regulatory changes since the B-Fund program was initiated in 1996, and focus on (a) the criteria for eligibility to draw subsidy support and (b) the updating of the high cost proxy used to derive the level of subsidy disbursements. Our goal is to enable the forces of competition to set appropriate prices while preserving access to affordable telecommunications services in high cost areas of California.³

This decision completes the review required by the legislature in Senate Bill (SB) 1276 (Chapter 847, Statutes of 2004) to update the B-Fund and evaluate reducing the size of the B-Fund. Our review revealed that the existing level of the B-Fund benchmark threshold is overly inclusive and results in subsidies to basic lines beyond the level that is required to meet the Commission's universal service goal of a 95% penetration rate for basic service.

In crafting of reforms to the B-Fund program, we note reforms being considered at the federal level,⁴ and shared concerns regarding the need to rein in the growth in subsidy levels paid to support universal service goals.⁵ In this interim order, we scale back B-Fund subsidy levels by raising the threshold benchmark for defining "high cost" areas. We will thereby target support levels more efficiently to cover only those "high cost" areas where funding is necessary to meet universal service goals. The act of updating the benchmark threshold will reduce the overall amount of high cost support provided to COLRs, and will produce a significant consumer benefit as the surcharge on all California consumer bills will be reduced going forward.

We specifically update the high-cost benchmark from the current $20.30 level to $36 per line. While the $20.30 benchmark is based on stale system-average cost data, the $36 benchmark level reflects a more contemporary perspective, embodying broad-based demographic trends in spending for local exchange services. The $36 benchmark provides a reasonable framework within which B-Fund support levels can be targeted, consistent with our universal service goals. As a result, subject to the transitional schedule for implementation adopted herein, primary residential lines with associated costs of basic service below the revised benchmark will no longer garner B-Fund support.

In order to facilitate a smoother transition, the changes in the threshold benchmark adopted herein shall be phased in gradually in four tranches beginning January 1, 2008, and concluding by July 1, 2009. We likewise reduce the B-Fund retail surcharge from 1.3% to 0.5% effective January 1, 2008. With this surcharge reduction, customers will realize tangible benefits in the form of lower bills. There is no reason to delay implementing reductions to the B-Fund subsidy draw until full basic service pricing flexibility takes effect. We did not change the level of basic rates when the CHCF-B support levels were first established, and likewise need not change basic rate levels as a result of the revisions in B-Fund support levels implemented herein.⁶

While the $36 benchmark will serve as the basis for identifying and limiting the residential lines eligible for B-Fund support, the revised benchmark is not intended to serve as the basis for setting basic rate cap levels. As explained below, we shall separately determine suitable transitional increases in the basic service rate caps for each respective ILEC in the next phase of this proceeding to avoid any risk of rate shock.

We note that in retaining the high cost fund, California remains on the vanguard of states with an explicit high cost program. Twenty-two other states have created high cost funds since California created the second state high cost fund more than a decade ago. With this decision we reaffirm our commitment to ensuring affordable telecommunication services are available to all Californians, and that the best means of achieving this goal is to ensure all telecommunication carriers in the state contribute in an equitable and explicit manner.

With these reforms, we will rely more upon competitive market forces, rather than regulatory subsidies that favor only one technology, to keep basic rates affordable. We conclude, however, that complete elimination of the B-Fund program is not feasible at this time or in the interests of consumers. We are concerned that the cost for basic service at least in certain high cost areas still exceeds reasonably affordable levels, thus requiring some continued subsidy. We thus permit the B-Fund program to continue on a more limited basis, at least for the present time.

The B-Fund was to be reviewed every three years, but this is the first comprehensive review conducted by the Commission since the creation of the
B-Fund in 1996, more than ten years ago. In response to legislative directives, our review of the B-Fund shows that there is a continuing need for high cost support; however, as noted above, updates to the B-Fund should be undertaken. Much has changed since 1996, and while the process selected by the Commission has performed well, in this phase of the proceeding we will perform some ministerial updates to important parts of the methodology. Since qualifying "high cost" areas were last identified in 1996, California has experienced dramatic changes both in demographics as well as technological innovations in the market for voice services. As a result, continuing to rely on such data to support B-Fund subsidies has become increasingly untenable. Because the cost data underlying existing B-Fund subsidy support levels is significantly outdated, cost proxies for high cost areas must be revised.

In the next phase of the proceeding, we shall complete the long overdue update of the relevant cost proxies for deriving subsidy draws, as explained below. Our goal shall be to complete this update expeditiously. As a longer term goal, in the next phase of this proceeding, we intend to institute a market-driven reverse auction process to determine high cost support levels.

The existing rate freeze applicable to basic exchange service for URF ILECs is scheduled to remain in place pursuant to legislative directive pursuant to Digital Infrastructure and Video Competition Act (DIVCA) until January 1, 2009, with the exception that rate increases for basic exchange service limited to the rate of price inflation are permissible before that date, as applicable under Section 5040 of the Public Utilities Code which codifies provisions of the DIVCA. Pursuant to this order, we shall adopt the following transition process for lifting the freeze on basic exchange service.

While our ultimate goal remains to rely upon competitive market forces to determine the appropriate pricing of basic services, we believe a transition process is necessary to avoid the potential "rate shock" of sudden, large retail basic rate increases in response to reforms that we adopt herein. In this manner, we ensure just, reasonable and affordable rates as required by Pub. Util. Code § 451. In the next phase of this proceeding, therefore, we shall devise an interim process for a gradual phase-in of any increases to basic rate levels to provide an orderly transition to full pricing flexibility. As a basis for calculating the applicable level of increases, we shall establish a target cap for each COLR, to be determined in the next phase of the proceeding. We shall also set a discrete time period over which the target capped rate shall be phased in. Once the targeted cap is reached, we shall thereafter remove the cap restrictions and grant full pricing flexibility for each COLR to make any subsequent adjustments in basic rates based on competitive market forces. We do not intend to apply rate caps any longer than is reasonably necessary to promote an orderly transition to full pricing flexibility. Of course COLRs may refrain from any basic rate increases, depending on competitive market forces in their service areas.

Effective January 1, 2008, we authorize an initial increase in basic service rates for AT&T and Verizon based on the applicable rate of inflation as measured by the Consumer Price Index published by the Bureau of Labor statistics, as provided for under DIVCA.⁷ In its comments on the Proposed Decision, DRA proposes use of the "CPI-U" which represents the broadest of the CPI measures. We agree that use of the CPI-U is reasonable for calculating the applicable rate increase effective January 1, 2008. As noted by DRA, that index stood at 203.5 in July 2006 and 208.299 in July 2007 (the most recent month for which the index is available). Thus, the applicable rate cap increase for AT&T and Verizon effective January 1, 2008 based on the CPI figures is 2.36%. We authorize AT&T and Verizon to file advice letters to implement basic rate increases to become effective January 1, 2008, consistent with this authority, if such carriers desire to do so. Should AT&T or Verizon choose to increase its basic rate with the 2.36% increase, the new basic rate shall constitute a new cap on basic rates effective January 1, 2008. Therefore, the ILEC may elect to charge less than the capped amount, but may not charge more.

As noted above, in the next phase, we shall determine the magnitude of further increases in the basic rate caps for each of the four ILECs to take effect on January 1, 2009, and concurrently establish a process for phasing in additional annual increases in the cap in order to avoid the risk of sudden, large rate increases for basic service. The phase-in of rate cap increases will provide an orderly transition to full pricing flexibility.

As a basis to receive B-Fund support after full pricing flexibility takes effect, however, we shall require that a COLR certify that it is not charging rates for basic service in excess of the benchmark levels that we establish herein. If a COLR sets charges for basic service in excess of the benchmark amounts adopted herein, the COLR shall no longer receive B-Fund support. A COLR that does not make the required annual certification must provide a detailed showing as to why they are unable to comply with the Commission's Rules. The Commission will evaluate the evidence and determine what, if any, action is required.

We select the Hatfield Model (HM 5.3) as the basis for performing necessary high-cost proxy updates for use in calculating B-Fund support levels. As explained below, however, we recognize the limitations of the available modeling tools to perform cost proxy updates, particularly since the costs measured through the modeling process reflect a traditional ILEC-voice-centric technology. Therefore, we also intend to move forward in the next phase with implementation of a market-driven reverse auction process as a basis to determine appropriate levels of high-cost support. We acknowledge that a reverse auction process ultimately offers a superior solution to cost proxy model updating as a basis for determining appropriate B-Fund support levels. We also recognize, however, that certain cost proxy updating may be necessary or desirable as a transitional measure. In the next phase of this proceeding, we shall determine more specifically how to sequence and prioritize the respective tasks involved in implementing the reverse auction and in conducting necessary updating of high-cost proxies.

In this order, we also conduct further inquiry in Phase II of this proceeding to consider implementing a "California Advanced Services Fund" (CASF) to provide limited funding under Pub. Util. Code § 739.3 for deployment of broadband facilities in unserved and underserved high cost areas of California. We intend to initiate this new initiative through the CHCF-B program, in recognition of the statutory goals for telecommunications in California "to encourage the development of new technologies."⁸ It would be imprudent to continue to only support legacy copper networks of ILECs through the universal service programs, recognizing that basic voice telephone service is being provided increasingly through advanced technologies such as VOIP and wireless technologies, including broadband systems.

A limited allocation of B-Fund money would be used to pay for certain infrastructure costs of broadband facilities in California high cost areas, with the express goal of minimizing any rate disparity between high cost areas and urban areas and to ensure goals of universal telephone service are met. As an initial funding source for the CASF, it may be appropriate to direct a portion of the already collected and appropriated B-Fund contributions on a limited basis.

As noted above, the B-Fund surcharge will be lowered on January 1, 2008 to reflect the reduced level of subsidy draw that will result from raising the high cost threshold. Maintaining an increased B-Fund contribution surcharge until January 1, 2008 is necessary as the phase-in of the new benchmark does not begin until that date. Therefore, we refrain from lowering the B-Fund surcharge until that time, and instead consider, in a subsequent phase, to what extent existing B-Fund contributions should be used by the CASF component of the CHCF-B.

In the next phase of this proceeding, we shall also determine the specific administrative processes to be implemented so that eligible candidates can apply for and be granted authority for disbursement of funds from the CASF for broadband deployment as noted above.

¹ See D.06-08-030, at 132.

² Because the ILEC basic rates were set based upon an average between high and low cost areas, including profitable and less-profitable areas, basic residential rates in High Cost areas were internally subsidized by revenues from more profitable exchanges, subsidies between product lines, and from other sources of revenues. (See Decision (D.) 95-07-050; 60 CPUC 2d, 536, 546.)

³ Cal. Pub. Util. Code §§ 709(a), 709.5(a).

⁴ On May 1, 2007, the Federal-State Joint Board on Universal Service released a Public Notice seeking comment on several proposals for possible reforms including reverse auctions, GIS technology and network cost modeling, disaggregation of support, support for competitive carriers, and broadband support. Federal-State Joint Board on Universal Service Seeks Comment on Long Term, Comprehensive High Cost Universal Service Reform, WC Docket No. 05-337, CC Docket No. 96-45, Public Notice, FCC 07J-2 (Fed.-State Jt. Bd., rel. May 1, 2007) (Public Notice).

⁵ In its Recommended Decision released the same day as the Public Notice seeking further comment, the Federal-State Joint Board expressed concern that High Cost support at the federal level has been rapidly increasing in recent years, and found that immediate action is needed to restrain growth in the funding of eligible carriers by imposing an interim cap on high cost support. Federal-State Joint Board on Universal Service, WC Docket No. 05-337, CC Docket No. 96-45, Recommended Decision,
FCC 07J-1 (Fed.-State Jt. Bd., rel. May 1, 2007) (Recommended Decision).

⁶ The Commission began updating its telecommunications policies in the late 1980s to respond to significant changes in the telecommunications marketplace resulting in adopting the New Regulatory Framework (NRF) for the companies now known as Verizon and AT&T. Re Alternative Regulatory Frameworks for Local Exchange Carriers, D.89-10-031, 33 CPUC 2d 43, 61 (1989). The Commission authorized the NRF for Frontier and SureWest in Re Citizens Utilities Company of California, D.95-11-024, 62 CPUC 2d 244 (1995), and Re Roseville Telephone Company, D.96-12-074, 70 CPUC 2d 88 (1996), respectively. In the second triennial review of NRF, the Commission effectively suspended the price-cap index and capped the basic service prices the companies could charge. Re Incentive-Based Regulatory Framework for Local Exchange Carriers, D.95-12-052, 63 CPUC 2d 377, 381 (1995). At that time, the basic rate was established to recover half of the companies' costs, and other rate elements were established to recover the remaining half of the costs. In D.96-10-066, the Commission created the B-Fund and ordered the companies to reduce many of those other non-basic rate elements. For example, D.98-07-033 adopted $305.2 million in rate reductions in toll, switched access, ZUM/local usage, and custom calling features for Pacific Bell to offset explicit subsidy support provided by the B-Fund. Companies that did not reduce non-basic rates were directed to surcredit the B-Fund support to their customers. In D.06-08-030 the Commission removed most remaining price constraints on rates other than that for basic service, which remained capped until at least January 1, 2009.
D.06-08-030 thus has the effect of removing the constraints on prices that were reduced by the creation of the B-Fund.

⁷ Since SureWest and Frontier do not currently hold video franchises, they are not eligible for rate increases under the provisions of DIVCA, but remain subject to the basic rate freeze until January 1, 2009. The surcredits applicable to Frontier shall be phased out in tandem with the phased implementation of the revised high-cost benchmark threshold, as described elsewhere in this order.

⁸ Pub. Util. Code § 709(c).