8. Should Pacific be Required to Reduce its Rates to Reflect the Elimination of the Pooling Payments?

8.1. Pacific's Position

The intervenors proposed that Pacific's rates be reduced to account for elimination of the payments to the Small LECs. Pacific asserts, however, that the Commission has eliminated this cost change as a Z-factor or Limited Exogenous (LE) factor. Pacific states that even if the Commission had not already put this issue to rest, Pacific has refunded more than it received in start-up revenue under NRF for pooling payments to Small LECs such that there is nothing in Pacific's rates recovering these amounts, rather Pacific is suffering a significant shortfall in recovering these costs.

Adjustments made to Pacific's rates in the past, when pooling payments were terminated, were made under the Z-factor mechanism of NRF, before the Commission eliminated Z-factors in D.98-10-026.²⁸ In that decision, the Z-factor mechanism was replaced by the LE factor which allows adjustments only for 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. Further, in D.98-10-026, the Commission stated that:

Z-factor recovery shall be continued until fully implemented only for the following adjustments: (1) $200 to $500 capital to expense shift, (2) merger refund authorized in D.97-03-067, (3) gain on sale of land, (4) other billing and collections jurisdictional cost shift, (5) results of Order Instituting Investigation 92-03-052 regarding property taxes, (6) a $99.5 million annual reduction in Pacific's rates for post retirement benefits other than pensions (PBOP) and a $24.025 million annual reduction in GTE's rates for PBOPs, and (7) a $12.656 million reduction in GTE's customer notification and education program costs. (Id. at 93.)

The Commission added, "All other Z-factor recovery and adjustments shall be permanently eliminated effective immediately. (Id. at O.P. 1.f.) Changes in intraLATA toll pooling costs was not one of the issues that the Commission deemed appropriate to continue to consider as either a Z-factor or an LE-factor. In fact, D.98-10-026 specifically noted that changes in intraLATA toll pooling costs were excluded from LE-factor treatment.

Our elimination of new Z-factor adjustments means we will no longer authorize recovery for exogenous cost changes, such as Commission-adopted financial Accounting Standards Board accounting changes, changes in intraLATA toll pooling, or changes in federal or state tax laws. (Id. at 61.)

According to Pacific, the Commission put any risks associated with cost changes, formerly borne by California ratepayers, squarely on Pacific's shoulders. The risks of cost changes can either raise or lower Pacific's net income. The intervenors should not be able to selectively mete out cost changes to Pacific's detriment and treat these changes differently. This outcome destroys the intent of putting risk and reward for costs on Pacific's shoulders.

Also, Pacific asserts it proved that it has given back more in pooling payments than what is reflected in its rates through the startup revenue adjustment implemented by the Commission in D. 89-12-048. Pacific provided the Commission with the pooling payments made to each company for the period 1989 to 1999, and the costs included in the startup revenue requirement. Pacific asserts that simple calculations provide a reasonable demonstration that Pacific has paid substantially more than the costs reflected in the startup revenue requirement.

Pacific rebuts ORA's assertion that Pacific should refund pooling payments even if such payments are not reflected in Pacific's rates. ORA's original position, as stated in its prehearing conference statement, was that Pacific should only be required to refund EAS payments if those payments were reflected in Pacific's rates. (PHC Statement of ORA, at 4-5.) According to Pacific, requiring the company to refund money it is not collecting in rates amounts to a taking, and is unconstitutional.

ORA and AT&T contend the Commission did not intend to eliminate Z-factor treatment for changes in intraLATA toll pooling in D.98-10-026. In its Reply Brief, Pacific criticizes AT&T's argument that the elimination of intraLATA toll pooling is not a "change" and therefore this exclusion does not apply in the present circumstances. Pacific contends that the elimination of intraLATA toll pooling that is occurring through this application fits within the plain meaning of the word "change." In any event, the only previous Z-factors recognized by the Commission were for elimination of pooling payments and, in fact, never recognized year-to-year pooling changes. Thus, elimination of pooling payments is exactly what the Commission must have meant by using the world "changes," and exclusion from Z-factor treatment does apply to the present circumstances.

Pacific asserts that ORA and AT&T mistakenly argue that an LE factor could be applied here under the chimera that this is a matter mandated by the Commission. Their contention is illogical because the Commission specifically eliminated intraLATA toll pooling as one of its Z factors and did not include it as one of the six types of adjustments that would continue to have the potential for Z-factor recovery. Pacific states that if the Commission intended for intraLATA toll pooling to continue to be subject to a recovery mechanism, it would have included it as one of the adjustments that remained subject to Z-factor recovery. It did not do so. Accordingly, the elimination of intraLATA toll pooling is not subject to either Z-factor or LE-factor recovery.

Pacific defends its Exh. EGB-2 presented by witness Borsodi, and says Borsodi explained the difference between EGB-2 and Appendix C, p. C-1 of D.94-09-065. As he explained, Appendix C is a "sources and uses" document which was designed to achieve a zero result when all items on the page are totaled. In contrast, EGB-2 is a listing of the rate increases or rate reductions resulting from a series of Commissions orders and resolutions over a period of almost 10 years. The underlying decisions and resolutions cited in EGB-2 support the positive and negative nature of numbers listed in that Exhibit. According to Pacific, comparing the two exhibits in the manner ORA proposes is like comparing apples and oranges.

8.2. ORA's Position

ORA asserts that Pacific has failed to justify the retention of funds it will no longer be paying into the various settlements pools. Pacific contends that the termination of Pacific's payments to the Small LECs does not qualify for LE factor treatment. In support of this position, Pacific's witness Borsodi attached a chart (Exh. EGB-2) to Exh. 8 that purports to show a cumulative shortfall of $279 million and a current annual shortfall of approximately $31.6 million as a result of various Commission decisions affecting settlement payments to small carriers by Pacific. However, when questioned about this figure, Pacific's witness characterized page C-1 of Appendix C of D.94-09-065, as a "sources-and-uses" statement of cash flow that has the effect of returning everything to zero. Further, under cross examination, Pacific's witness was unable to provide an adequate explanation of why Exh. EGB-2 reverses the signs that appear in Appendix C.

According to ORA, Pacific's alleged loss of $279 million is a chimera. ORA notes that Pacific's witness acknowledged that his employer had sought Z-factor rate adjustment for a number of items that are far smaller than $25 million. It strains credulity for Pacific to contend that until November 1999, Pacific had no knowledge that it was losing between $25 to $30 million per year and had made no effort to recover this loss from the Commission. (1 R.T. 93.)

ORA also notes that D.98-10-026 provides that the Commission can provide LE-factor treatment for (1) matters mandated by the Commission. Changing the source of settlement payments from direct payments from Pacific to the CHCF-A is precisely the type of regulatory mandate the Commission had in mind when it promulgated the LE-factor criteria in D.98-10-026. The Commission should order LE-factor treatment for the funds to ensure that the monies do not become a windfall for Pacific.

In its Reply Brief, ORA notes that the language of D.98-10-026 proscribing LE treatment for "changes" in intraLATA toll, access and EAS pooling costs, does not bar the Commission from affording such treatment to the outright termination of the toll, access and EAS pools. Termination of the pools is more than a mere change, but rather is something mandated by the Commission, and therefore eligible for LE treatment.

8.3. The IXCs' Position

Applicants have confirmed that the toll, access and EAS pools are operated separately and are governed by separate contractual agreements. The amount of the subsidy that Pacific currently pays to the Small LECs is approximately $37.2 million annually for all the pools, including approximately $16.9 million for the access pool. (Exh. 10, AT&T Testimony, Attachment 4.) If this application is approved, the Small LECs will increase their access charges and CHCF-A draws to recover this amount, while Pacific will not reduce its rates. As the IXCs and ORA have pointed out, applicants' proposal clearly leads to double payment of this $16.9 million by ratepayers. To prevent this double payment, the Commission should remove the entire subsidy from Pacific's access charges, effective with Pacific's termination of settlement payments to the Small LECs.

Pacific claims that it should not have to reduce its rates because it has already given back a larger amount related to inter-company settlements than it received in its start-up revenue requirement. Pacific argues that it has been using shareholder funds to make its settlement payments to the Small LECs under the pools (1 R.T. 90.) This claim is contradicted by the history and operation of the pools. Small LEC witness Tutt explained how the pooling process works. He stated that he had never seen the pools earn a negative rate of return (1 R.T. 49.). In other words, the pooled revenues for access service have always been sufficient to pay access costs of both Pacific and the Small LECs. Thus, Pacific has always made its settlement payments out of its revenues for access service, and has never needed to contribute additional funds of its own to the access pool to pay the Small LECs.

During hearings, Pacific's witness Borsodi explained Pacific's analysis entitled "Post-NRF Rate Reductions Associated with Settlements," which is Exh. EGB-1 to his rebuttal testimony. In this document, Pacific purports to show that the Commission allotted approximately $292 million for inter-company settlements in Pacific's start-up revenue requirement, but that the Commission subsequently made a series of settlement-related adjustments, which reduced Pacific's rates by a total of approximately $317 million. According to Pacific, this left it with a shortfall of approximately $25 million related to inter-company settlements. (Exh. 8, Borsodi for Pacific at 5, A6.)

The IXCs assert that although Exh. EGB-1 was prepared under Borsodi's direction, he was unable to explain key aspects of Pacific's analysis. Pacific claims that Borsodi obtained all of the adjustments shown in its analysis directly from Commission decisions and resolutions listed on Exh. EGB-1, but that is not true. In fact, Pacific reversed the effects of all eight adjustments it took from D. 94-09-065 Appendix C. Table C-1, such that positive revenue amounts listed in Table C-1 are shown as revenue reductions in Pacific's Exh. EGB-1, and vice versa. (Exh. 9.) Also, Borsodi was unable to explain why two adjustments that are revenue reductions in Table C-1-line 21 for PB/GTEC ZUM Access Charges and line 22 for PB/Roseville DCP MTS Billings-are shown as rate increases in Pacific's analysis.

Finally, during evidentiary hearings, Borsodi explained some clerical errors in his analysis. One of those related to IRD-adjustments where "somebody got the signs backwards or something." (1 R.T. 88.) This statement contradicts Pacific's contention that it has simply taken the revenue adjustments listed in its Exh. EGB-1 directly from Commission decisions and resolutions. If the amounts were the same as those ordered by the Commission, there would be no need for Pacific to change the signs on any of the adjustments. According to the IXCs, the minor clerical errors, combined with Borsodi's explanation, indicates that Pacific is playing with the numbers in order to arrive at its alleged shortfall. The IXCs state that Exhibit EGB-1 should be ignored by the Commission.

The IXCs assert that Pacific's claim that it only recently realized that it lost nearly $279 million in inter-company settlement payments to Small LECs during the period 1990-1999 is simply not credible. Prior to the filing of rebuttal testimony on April 28, 2000, Pacific had never mentioned these alleged losses in this proceeding. Also, Borsodi admitted that Pacific never filed for Z-factor recovery of any of these amounts, even though it had the right to do so for many years, and even though it filed for recovery of a number of other, much smaller amounts. (1 R.T. 90.) As administrator of the pools, Pacific has been well aware of the revenues, costs, and rates of return associated with Pacific's own contributions to the pools.

Because the pools have never earned a negative rate of return, it is clear that Pacific has never contributed its own funds to the pools. Thus, contrary to its claims, Pacific has experienced no shortfalls related to settlements.

The IXCs assert that Pacific's claim that the NRF decision exempts it from reducing its rates in this proceeding is an erroneous reading of D.98-10-026. The section of the NRF decision to which Pacific refers states, "Our elimination of new Z factor adjustments means we will no longer authorize recovery for exogenous cost changes, such as...changes in intraLATA toll pooling." In Borsodi's opening testimony, Pacific attempted to seize on the word "changes", characterizing the termination of its contractual agreements with the Small LECs - and the accompanying termination of approximately $37.2 million in settlement payments-as mere "payment changes," in order to rely on the Commission phrase, "changes in intraLATA pooling," in the citation above. (Exh. 7 at 4-5.) According to the IXCs, this is an erroneous reading of the NRF decision. The elimination of Pacific's settlement payments to the Small LECs is neither a change in the amount of those payments nor a change in the way intraLATA toll pooling operates. Nor is the elimination of a process a "large change" in that process, as Pacific attempts to imply in Borsodi's rebuttal testimony. (Exh. 8 at 3.)

More importantly, the IXCs state, Borsodi admitted in his opening testimony that the NRF decision states that LE factors may be ordered for "matters mandated by the Commission." (Exh. 7 at 3-4, citing D.98-10-026 at 61.) Because this application clearly involves the elimination of Pacific's pooling and settlement processes with the Small LECs, rather than "changes" in those processes, the Commission has full authority to order Pacific to reduce its rates via an LE factor adjustment to remove the implicit subsidies Pacific will no longer be paying to the Small LECs. (Exh. 11 at 10-11.)

As AT&T noted, the Commission correctly required Pacific to reduce its rates previously when Pacific similarly terminated settlement payments to GTE, Contel, Citizens and Roseville. (Id.) The termination of settlement payments to the Small LECs is no different than these other cases and merits similar treatment, via LE factor adjustment, by the Commission.

8.4. Discussion

The resolution of this issue turns on parties' varying interpretations of D.98-10-026. We will clarify our intent in that decision, but to place our discussion in context, we must first summarize the history of exogenous factors in NRF. When we first adopted the NRF framework for Pacific in D.89-10-031, we included changes in IntraLATA Toll Pooling as one of the initial Z-factors:

As a starting point, we accept the following factors: changes in federal and state tax laws to the extent they affect the local exchange carriers disproportionately, mandated jurisdictional separations, changes to intraLATA toll pooling arrangements or accounting procedures adopted by this Commission, changes in regulatory amortizations such as expensing of station connections, and reflection of tax benefits resulting from premature retirements of high coupon bonds pursuant to D.88-12-094.²⁹

In other words, changes in intraLATA toll pooling arrangements were clearly delineated as an allowable exogenous factor. And in fact, as the IXCs point out, when Pacific terminated settlements payments to Contel, Citizens, Roseville and GTEC, the elimination of those inter-company settlement payments was reflected in Pacific's rates.

At the end of 1998, after we approved Z-factor treatment for those settlements adjustments, we issued D.98-10-026. That decision in the Third Triennial Review of our NRF program for Pacific & GTEC made substantial changes in the treatment of exogenous factors. We eliminated consideration of any new Z-factor adjustments. (D.98-10-026 at 60.) We also examined all existing Z-factors, including intraLATA toll pooling, and determined which Z-factors should be phased out over time. We developed a list of seven items which would be allowed continued Z-factor treatment on a limited time basis. IntraLATA toll pooling was not included on that list of allowable Z-factors. To the contrary, we specifically excluded changes in intraLATA toll pooling, as Pacific cited above, as follows:

Our elimination of new Z-factor adjustments means we will no longer authorize recovery for exogenous cost changes, such as Commission-adopted Financial Accounting Standards Board accounting changes, changes in intraLATA toll pooling, or changes in federal or state tax laws. (Id. at 61.)

In other words, we made it clear that intraLATA toll pooling would no longer be included among allowable Z-factor adjustments.

According to ORA and the IXCs, while we eliminated intraLATA toll pooling as a Z-factor, it could be treated as an LE factor, under the new criteria adopted in D.98-10-026. In order to clarify our intent in that decision, we need to review the entire relevant portion of the text, including the portion cited above:

Our elimination of new Z-factor adjustments means we will no longer authorize recovery for exogenous cost changes, such as Commission-adopted Financial Accounting Standards Board accounting changes, changes in intraLATA toll pooling, or changes in federal or state tax laws. We will, however, allow continuation of a streamlined process for requests in two narrow areas: requests for 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. (Ibid.)

The IXCs assert the inter-company settlement payments should be included as an LE-factor because it fits the criteria of number (1) "matters mandated by the Commission." We agree that we have the authority to mandate the termination of the inter-company settlements payments from Pacific to the Small LECs, and are doing so in this order. However, ORA's and the IXCs' interpretation of our intent is not correct. As cited above, we eliminated recovery for exogenous cost changes for intraLATA toll pooling for Pacific and GTEC. Our former Z-factor and the LE-factor we adopted in D.98-10-026 both relate to "exogenous cost changes" so we clearly intended that intraLATA toll pooling would be exempt from either Z-factor or LE-factor treatment when we said that we would not authorize recovery for exogenous cost changes for changes in intraLATA toll pooling.

Both ORA and the IXCs have provided a strained interpretation of the phrase "changes in intraLATA toll pooling" cited above from D.98-10-026 and have concluded that the elimination of pooling does not constitute a "change." We disagree with this interpretation of our decision. We agree with Pacific that the elimination of intraLATA toll pooling that is occurring through this application fits within the plain meaning of the word "change." As Pacific points out, previous Z-factors recognized by the Commission were for elimination of pooling payments and never for year-to-year pooling changes.

ORA's and the IXCs' proposal that Pacific reduce its rates by the approximately $37.2 million in payments it no longer makes to the Small LECS is rejected, as it is inconsistent with our directive in D.98-10-026 that intraLATA toll changes not be treated as exogenous factors. Therefore, the analysis of whether or not Pacific has paid more than its start-up revenue requirement is moot, and will not be addressed.