XII. Centrex Service

Centrex is a central office based business telecommunications system that permits customers to identify and select a variety of features to be deployed on stations. A Centrex business system consists of an access line, or loop, for each station on the system and both ordinary and special functions provided by

Pacific Bell's central-office switch. A Centrex business system allows feature selection to be customized at the customer's option for any business with two or more lines. Ongoing customer requirements for Centrex are met through technology upgrades deployed at the central office. Both analog and digital formats are available. Analog Centrex is offered as Basic Centrex²² and Centrex DMS-100 Electronic Business Sets. Digital Centrex is offered through Centrex ISDN and provides customers with Basic Rate ISDN capabilities-integrated voice and data communication.

The Basic Centrex Line was classified as a Category I service in 1989, pursuant to D.89-10-031.²³ By that same order, the Commission found that Centrex features were discretionary or partially competitive. Hence, Centrex features were placed in Category II. Subsequently, the Basic Centrex Line was re-categorized from Category I to Category II in 1994 because it was found to be a close substitute and discretionary alternative to Private Branch Exchanges (PBX).²⁴ Centrex and PBX services require access to the public switched network through a loop or trunk line. Basic Centrex Line and Centrex features are currently classified as Category II services.

A. Centrex Proposal

Pacific Bell seeks authority to re-categorize its Centrex service from Category II to Category III and to continue treating these services as above-the-line services for ratemaking purposes. The details of Pacific Bell's proposed tariff changes were attached to the application as Exhibit A, as amended by a September 30, 1998 filing. Because of the voluminous changes to its tariffs consisting of more than 300 individual features, Pacific Bell's proposed changes were not identified in detail. However, to put Pacific Bell's request in perspective, the following tabulation compares the maximum price of Pacific Bell's four primary components of Centrex service in its current Category II classification and the proposed Category III classification.

Current Proposed Percent

Service price maximum increase

Basic Centrex Line $8.35 $16.70 100%

Basic Features 2.07 4.14 100

Optional Station Features Price Varies Price Varies 100

Optional System Features Price Varies Price Varies 100

B. Pacific Bell's Position

Pacific Bell represented that the relevant market, ability of competitors to enter and exit the Centrex market, demand elasticity, and supply elasticity substantiate that its Centrex service should be re-classified from Category II to Category III. Pacific Bell concluded that it maintains an insignificant market power for its Centrex service and does not have the ability to price its Centrex service above a competitive level for a period of time.

1. Relevant Market

Pacific Bell identified the relevant market to its Centrex service to include business systems such as facilities-based Competitive Local Exchange Carriers' (CLECs) alternative services, PBX, and Key Set Systems. Facilities-based CLECs have either their own switches and outside plant facilities or purchase Pacific Bell's unbundled elements and repackage them to their customers.

A PBX system is a customer-owned premise-based system that literally allows customers to perform and use the same functions as Centrex. PBX owners are responsible for upgrading, maintaining, and programming of their premise-based system. PBX owners also use telephone sets similar to Centrex.

A Key Set System (Key System) is comprised of telephone sets, business access lines, and subscriber features. A Key System has much of the same feature functions as PBX and Centrex, but is not connected to a "system" that allows a dialing plan or "network" features.

2. Entry & Exit

Pacific Bell testified that it has experienced a significant increase in direct competition within its Centrex market since 1994 due to the ease of entry and exit in the relevant Centrex market. This is because the smaller customers typically opt for less expensive Key System due to the minimal up-front capital investment and the larger customers typically opt for PBX business systems. Hence, customers have a choice of purchasing the type of their business system. These alternatives make it very difficult for a Centrex monopolist to raise its Centrex price by a significant non-transitory amount without customers switching to PBX and Key Systems. As shown by the following tabulation, Pacific Bell's cost comparison between Centrex, PBX, and the Key Systems demonstrate that the cost for each business system is comparable.²⁵

Line Size	Centrex	PBX	Key System
2- 20	$ 2,440-$22,800	-	$4,833-$10,041
21- 100	23,920-112,400	$82,318-91,219	9,666-25,571
101-400	113,520-448,400	83,878-347,065	-
401-1000	344,044-1,120,400	344,044-836,316	-

3. Demand Elasticity

Based on marketing studies, Pacific Bell found that its Centrex market has remained at a static 15% market share since the fourth quarter of 1997. ²⁶ At the same time, competitive PBXs hold a 41% market share and Key Systems a 43% market share.

Pacific Bell began providing Centrex service in 1962. Although Pacific Bell also provided PBX and Key Systems service to its customers, it has not provided these services since 1982, pursuant to the terms of the AT&T antitrust consent decree. Pacific Bell found similar insignificant market share results within any grouping by size of the users as shown in the following tabulation. Thus, Pacific Bell concluded that it does not have the ability to raise its price above competitive levels for Centrex service.

Number of Equivalent Stations	Pacific Bell's Share
2 - 20	22.5%
21 - 100	24.5
101 - 400	19.3
401 - 1,000	19.0

4. Supply Elasticity

Pacific Bell identified six major competitors that offer Centrex service, seven that provide PBX, and nine that provide Key Systems. The Centrex competitors are GTE of California, Brooks Fiber, "MFG", Teleport Communications Group (TCG), "ELI", and "GST". The PBX competitors are Siemens and Rolm, Mitel, Ericsson, Fujitsu, and Hitachi. Key System competitors are Toshiba, NEC, Panasonic, Nitsuko, Executone Info Sys, Comdial, and Inter-Tel. In addition, Lucent and Nortel compete in the Centrex, PBX and Key System markets. Pacific Bell utilizes both Lucent and Nortel for its Centrex systems.

Pacific Bell found that PBX and Key System manufacturers face no significant barriers to expansion. This is because most manufacturers operate in national and international markets. That enables them to increase their product supply to California in a relatively short period of time and at a comparable price.

5. Cost Support and Ceiling Rate

Cost support for the rate elements Pacific Bell seeks to move from Category II to Category III were submitted as part of its application and testimony. Upon Pacific Bell's request and without any opposition from interested parties, the cost data was placed under seal pursuant to Pub. Util. Code § 583 and General Order 66-C. The sealed cost data included the results of Pacific Bell's Total Service Long Run Incremental Cost (TSLRIC) to support its Centrex Line, Centrex Basic Features, and Centrex Optional Features cost and price floors. The cost data for these services were identified at the rate element level by long-run incremental volume sensitive cost, non-volume sensitive cost,

and non-recurring cost. Such cost data was also based on previously filed Open Access and Network Architecture Development (OANAD) Phase II cost studies for the provision of products approved by the Commission pursuant to D.96-08-021. However, Pacific Bell offered no support to substantiate its request to raise the ceiling rate for each of its Centrex services by 100%.

Centrex Station and System Features costs and price floors were based on non-recurring cost previously filed in Pacific Bell's OANAD Phase II cost studies and re-occurring cost based on the Implementation Rate Design (IRD) methodology set forth in D.94-09-065. The price floors for these Centrex Optional Features were also filed in the 1998 Implementation Monitoring Report.

All data placed under seal should remain sealed for a period of one year from the date of this order. The sealed cost data should not be accessible or disclosed to anyone other than Commission staff during the one year time period. However, such sealed data may be accessible or disclosed upon the execution of a mutually acceptable nondisclosure agreement or on further order or ruling of the Commission or the ALJ then designated as the Law and Motion Judge, the assigned ALJ, or the assigned Commissioner.

C. AT&T, MCI WorldCom, & CCTA's Joint Position

AT&T, MCI WorldCom, and CCTA opposed Pacific Bell's request for Category III treatment of its Centrex service on the basis that Pacific Bell retains a substantial degree of market power over Centrex service. Protestants do not dispute that Centrex and PBX services are similar services. For example, Centrex and PBX services offer customers similar features such as intercom calling and call forwarding. However, these protestants assert that the level of competition that exists in the market for telecommunications equipment has no bearing on whether Centrex should receive Category III status. The opposition is based on the fact that Centrex and other telecommunications equipment, such as PBX, are dependent on the use of Pacific Bell's access lines through a Centrex loop or a PBX trunk, and both require the use of Pacific Bell's local switching capability²⁷.

These protestants assert that Pacific Bell's share of the business access line market is virtually unchanged from where it stood two years ago. For example, Pacific Bell retains an over 95% share of the business access line market, and an over 98% share of the residential access line market. In regards to the local switching market, Pacific Bell has over 780 local switches within its service territory, while its competitors have only 50 local switches throughout the entire state.

The protestants conclude that Pacific Bell retains a virtual monopoly over access lines and local switching within its service territory and customers do not have a choice of providers for the access lines and local switching they need to make their telecommunications equipment work. The protestants also conclude that Pacific Bell's virtual monopoly over access lines and local switching allows Pacific Bell to engage in vertical price squeezes, cross-subsidies, and non-price discrimination against competitors for its Centrex service.

D. ORA's Position

ORA concurred with Pacific Bell that it's Centrex service competes with vendors of PBX and Key Set Systems, and CLECs. However, ORA opposed Pacific Bell's Category III and increased ceiling rate request for the Basic Centrex Line on the basis that Pacific Bell failed to substantiate most of its market power allegations with relevant data, failed to consider relevant sub-markets, and that Pacific Bell retains monopoly control over the Basic Centrex Line.

ORA's sub-market position was based on its interpretation of the D.89-10-031 requirement that a market power test must be performed in each market a LEC serves. ORA contends that its sub-market position is further supported by D.87-07-017, which looks to relevant sub-markets, market segments, and the overall market for a service, to determine the degree of regulatory flexibility that should be granted to a particular service provider. Consistent with its interpretation, ORA identified two primary sub-markets that Pacific Bell should have considered in its market power analysis. They are Basic Centrex Access and geographically identified markets.

Based on ORA's independent market power analysis of Pacific Bell's Basic Centrex Access sub-market, ORA concluded that Pacific Bell controls over 98% of this sub-market, a substantial share of the access line sub-market. ORA also concluded that Pacific Bell's dominance over the Centrex Access sub-market would preclude a finding that Pacific Bell's Centrex service is fully competitive.

ORA did not dispute that Centrex service is provisioned on a bundled basis. However, it concluded that Centrex service should continue to be evaluated by each component of Centrex service so long as Centrex service contains access lines, a monopoly building block. ORA is concerned that Pacific Bell's control of this building block would allow it to potentially limit, delay or deny its competitors access to the Basic Centrex Access components. ORA is also concerned that Pacific Bell could price-squeeze its competitors by lowering the overall price it charges for bundled Centrex service, while maintaining the existing discount rate provided to resellers, and the Unbundled Network Elements (UNE) wholesale prices to its competitors for the Centrex local loop and PBX trunk access components.

ORA considered the importance of geographical sub-markets because facilities-based competitors in rural areas may have a minimal presence, if any. To the extent that facilities-based competitors may exist in the rural areas, ORA was concerned that competition may only exist over scattered pockets of the rural area and PBX and Key System providers have no alternative but to purchase their business lines from Pacific Bell.

ORA concluded that Centrex service does not merit Category III treatment because the end-users of PBX, Key System, and CLECs' Centrex equivalent services are dependent on Pacific Bell's access line facilities to provide their respective services.

Alternatively, if Pacific Bell is granted Category III status for its Centrex service, ORA recommends that the Commission's D.89-10-031 and D.94-09-065 imputation requirement continue to apply for Pacific Bell's Centrex service. That is, Pacific Bell should continue to impute the tariff rate of any function deemed to be a monopoly building block in rates for Centrex or Centrex-equivalent services.²⁸

ORA recommended that upon the issuance of a final OANAD decision, Pacific Bell submit an advice letter to revise the Basic Centrex Line price floor to comply with the OANAD adopted imputation and price floor requirements. ORA also recommended that the Centrex optional station and system features price floors be equivalent to their adopted Implementation Rate Design (IRD), Long Run Incremental Cost (LRIC) or TSLRIC. This is because ORA considered the optional station and system features to be competitive elements of Pacific Bell's Centrex offerings that exclude monopoly building blocks. With the issuance of the recent OANAD decision, D.99-11-050, these recommendations need not be acted on in this proceeding. That decision addressed and required Pacific Bell to comply with specific monopoly building block and price floor requirements.

ORA also recommended the establishment of safeguards to prevent Pacific Bell from engaging in anti-competitive behavior. ORA proposed that Pacific Bell continue to demonstrate that its Basic Centrex Access prices are equal to or above the respective price floor, and that Pacific Bell submit specific information²⁹ as part of its Centrex contract advice letters. Again, the recent OANAD decision has resolved ORA's anti-competitive contract reporting requirement concern. Hence, the anti-competitive contract concern need not be addressed further.

Although ORA did not object to Pacific Bell's proposal to raise the price of its Centrex Features by 100%, it did object to Pacific Bell's proposal to raise its Basic Centrex Line by the same percentage. ORA recommended that the Basic Centrex Line ceiling rate be set no higher than 10% above the present $8.35 tariff rate.

Finally, ORA concurred with Pacific Bell that any Centrex service components that are moved to Category III should be given above-the-line treatment for ratemaking purposes.

E. Market Power Discussion

There is no dispute among the parties that the relevant market for Centrex service consists of PBX Systems, Key Systems, and facilities-based CLECs. Hence, the measurement of Pacific Bell's market power should be based on the relationship between its Centrex service and the identified relevant market.

As identified in the prior entry and exit discussion, the PBX and Key Systems are a two business systems that perform similar Centrex functions, and which are comparably priced to the Centrex systems utilized by Pacific Bell. The comparably priced equipment, coupled with the availability of such equipment by numerous large established suppliers, demonstrate that competitive entities are willing to enter and remain in the relevant market for providing equipment features. This availability of relevant market competitors demonstrates the supply elasticity of the overall relevant market.

Because Pacific Bell has not provided or offered any PBX or Key System services since 1982, Pacific Bell's overall relevant market share of approximately 15% is based solely on its Centrex service. This insignificant market share does not provide Pacific Bell with the ability to retain or improve its overall relevant market share if it attempts to raise its prices above competitive levels. Hence, Pacific Bell has insignificant market power in the overall Centrex relevant market. However, this insignificant market power finding is not necessarily valid for each of the Centrex service sub-markets or components for which Pacific Bell seeks Category III status.

In its application, Pacific Bell requested that its Centrex service be moved from Category II to Category III based on a market power analysis of its packaged Centrex service consisting of four components. The four components, which were identified in the "Centrex Proposal" section, are Basic Centrex Line, Basic Features, Optional Station Features, and Optional System Features.

Although ORA asserted the need to address geographical sub markets, D.87-07-017 determined that the scope of the relevant market may change depending on the type of regulatory changes under consideration. For example, where competitive conditions may exist for pricing flexibility by geographic areas, a sub-market analysis may be appropriate. However, in D.99-11-050, the Commission concluded that geographical sub-market pricing flexibility was not appropriate at this time.

ORA also raised the issue of Pacific Bell's ability to engage in a price squeeze with competitors if its Basic Centrex Line is moved to Category III. ORA is concerned because Pacific Bell controls over 98% of the access lines within its service territory. Even though Centrex relevant market services require the use of some type of access facilities, the evidence does not substantiate ORA's claim. Pacific Bell is not seeking to reclassify all of its access lines to Category III. It is only seeking to reclassify its retail Centrex service.

Irrespective of Pacific Bell's share of access lines, there are Commission established safeguards in place to prevent Pacific Bell from attempting a price squeeze on its competitors. For example, access to unbundled loops is fully regulated as a Category I service. Alternative PBX service requires the use of PBX trunks, a Category II service subject to price floors and price caps regulated by the Commission. The Basic Centrex Line, by definition, if moved to Category III must be priced at or above cost. Hence, there is no risk of a price squeeze.

In regards to the market power analysis of the Centrex services, we have been convinced that Pacific Bell has insignificant market power in the Basic Centrex Line, Centrex Basic Features, Optional Station Features, and Optional System Features. This is because of the availability of numerous large established suppliers with the ability to offer competitive equipment features through Centrex, PBX, or Key Systems. In addition, Pacific Bell's participation in the Centrex relevant market is limited to only Centrex services. Furthermore, Pacific Bell is unable to price its Centrex features above a competitive level for a period of time, and to keep or increase its market share within the identified relevant market. For example, customers have the ability to change to an alternative Centrex provider or to a competitor's PBX or Key System Service should Pacific Bell attempt to increase the price for these services. The evidence also shows that other providers have the ability to defeat any attempted price increase for these services and that customers would find these competitive alternatives to be acceptable substitutes. Hence, Pacific Bell should be authorized to move its Basic Centrex Line, Centrex Basic Features, Optional Station Features, and Optional System Features from Category II to Category III.

F. Price Discussion

The ceiling rate rules established in Resolution T-15139, dated March 24, 1993, provided utilities with the flexibility to change a Category III service rate upon one-day's notice without protest if the new rate is below the service's ceiling rate. Hence, the higher the ceiling rate, the more pricing flexibility Pacific Bell will have. Consistent with its desire for more price flexibility, Pacific Bell proposed a 100% increase in its ceiling rate for each component of its Centrex service.

Only ORA provided evidence on what a reasonable ceiling rate should be if Pacific Bell's Category III requests are approved. ORA's evidence was limited to the Basic Centrex Line. Pacific Bell provided no evidence to substantiate its request for a 100% price increase. Upon questioning by ORA, Pacific Bell told ORA that although it requested a 100% increase in the ceiling rates for its Centrex service, it does not intend to ever price its Centrex service that high.³⁰

ORA recommended that if the Basic Centrex Line was moved to Category III that the ceiling rate should be raised no higher than 10% above the present $8.35 tariff rate. ORA arrived at its 10% figure by calculating the cumulative change in the inflation index from 1995 to 1998. A 100% increase in the Centrex ceiling rate is not supported by any evidence and should be rejected. The 10% increase is a realistic increase given the evidence in the record and should be adopted for all components of Centrex.

G. Above the Line Discussion

Pacific Bell requested that all components of its Centrex services that are moved to Category III should be given above-the-line treatment for ratemaking purposes. No party objected to the above-the-line treatment. ORA concurred on the basis that Centrex service does not face a high-risk of having plant potentially rendered not useful because of competition. Also, Centrex service has provided a contribution above its costs to keep the rates for basic exchange service lower than they would otherwise be for the past ten years.

We concur. The components of Centrex being moved to Category III by this order should continue to be given above-the-line treatment for ratemaking purposes.

H. Conclusion

Pacific Bell should be authorized to reclassify its Basic Centrex Line, Centrex Basic Features, Centrex Optional Station Features, and Centrex Optional System Features from Category II to Category III.

The ceiling rate for Centrex components should be limited to 10% above the currently effective ceiling rates. The limiting of ceiling rates by this order does not preclude Pacific Bell from seeking approval to further increase its Category III ceiling rates through the process set forth in Resolution T-15139, dated March 24, 1993. The re-categorized components of Centrex service should continue to be treated as above-the-line items for ratemaking purposes.