7. Timing for Implementing Revisions to the Benchmark

We next consider the question of timing of the implementation of the revised benchmark threshold of $36. We must determine whether it is appropriate to implement changes to the B-Fund benchmark threshold prior to granting full pricing flexibility to adjust basic rates. Alternatively, we consider to what extent, if any, changes to the B-Fund benchmark or surcharge should be deferred to coincide with the implementation of full pricing flexibility.

7.1 Parties' Positions

AT&T, Verizon, and SureWest argue that any changes to the benchmark should be implemented concurrently with lifting the freeze on basic rates, and granting full pricing flexibility as of January 1, 2009. AT&T argues that raising the benchmark (thereby reducing subsidy) while the rate freeze remains in place would be "disjointed" and impede the ILECs' continued ability to serve high cost areas, putting rural customers at greater risk. AT&T argues that any reduction in subsidy support while the basic rate freeze remains in effect would mean either (1) carriers lose money serving high cost customers, or (2) any shortfalls would have to be funded by raising prices for services other than basic service. AT&T contends that neither of these alternatives is appropriate.

AT&T argues that if it was forced make up reduced subsidies by raising rates for services other than basic service, the result would be to restore the very cross-subsidies that the B-Fund was designed to eliminate. AT&T argues that such cross-subsidization would conflict with the Commission's policy to promote competition by eliminating implicit price subsidies and encouraging carriers to price services in relation to actual costs.

The ILECs assert that if the funds provided to the COLR to subsidize high cost lines is reduced, then the Commission would be required to authorize an offsetting increase in basic rates to maintain revenue neutrality. The ILECs argue that principles of revenue neutrality must be enforced as long as there are basic rates which are not subject to full pricing flexibility.¹²¹ AT&T argues that without a revenue-neutral rate increase to offset a Commission-mandated reduction in B-Fund support, a justified "taking" would occur. At least for the duration of the period of price controls on basic service, the ILECs argue that they could not make up for a reduction in the authorized level of B-Fund support by increasing basic rates without Commission approval.

AT&T asserts that the Commission "recently agreed that when revenues are taken away from AT&T California by the Commission's actions, it is appropriate to provide for an offsetting revenue source."¹²² AT&T cites the Commission's action to lower intrastate access charges for the large ILECs, finding that "in past instances in which the Commission has ordered rates to be reduced [the Commission has] provided for revenue neutrality." The Commission stated that it "could only depart from the established policy with a compelling showing."¹²³

Cox, Sprint, Time-Warner, DRA and TURN dispute the ILECs' claims concerning revenue neutrality. They argue that changes to the threshold should be implemented now without waiting for the freeze on basic rates to be lifted on January 1, 2009. TURN favors the possibility of "downward revenue neutrality" if ILECs would gain a "windfall" by being allowed to keep subsidies without offsetting rate reductions.¹²⁴ These parties believe that Commission-mandated rate adjustments to compensate for reduced B-Fund support levels are unwarranted, and that revenue neutrality has no relevance in a competitive environment, even with a basic service rate freeze.¹²⁵ They argue that the COLR is able to adjust prices for all services except for basic services subsidized by the CHCF-B, and thereby to offset any reductions in CHCF-B draws.¹²⁶

DRA believes that the benchmark could be increased, without lifting the residential rate freeze (other than the effect of eliminating the CHCF-B surcharge and, where applicable, surcredits). DRA argues that any increased cost-threshold should only be used to reduce B Fund subsidy support, but not as a basis for increasing retail rates. DRA calculates that an increase in retail rates up to the FCC $34.21 "safe harbor" threshold, as Verizon contemplates,¹²⁷ would nearly double retail rates in the Verizon, Frontier and SureWest territories and more than double them in the AT&T territory.

7.2 Discussion

We find no valid reason why the benchmark cannot be revised, and subsidies reduced, prior to the time when the basic residential rate will be subject to full pricing flexibility. Consumers are entitled to relief from excessive burdens of B-Fund subsidies (as reflected in B-Fund surcharges) without undue delay. Reform in the B-Fund should proceed expeditiously and revisions to the threshold need not be delayed until full basic rate flexibility takes effect.

We strongly disagree with the ILECs' claim that the subsidy level can only be adjusted concurrently with the lifting of the rate freeze and granting full price flexibility. 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. Universal Service support is not an entitlement, and the relevant statutes do not automatically entitle designated COLRs to receive universal service support. Simply because the Commission has not varied in its determination of the fund since its inception does not create an entitlement for such support to carriers on a prospective basis.

In order to provide a smoother interim transition to the new benchmark level, however, we shall phase-in implementation of the new benchmark in stages. The first stage of implementation shall begin effective January 1, 2008. Subsequent adjustments in the threshold shall be implemented in six-month increments. The full implementation of the $36 benchmark shall take effect on July 1, 2009. Appendix Table 1 shows the estimated reductions in subsidy levels for each COLR associated with each successive adjustment, culminating in the $36 threshold. The Appendix Table 1 shows a cumulative reduction in subsidy support of approximately 74% from existing levels.

In comments on the Proposed Decision, CCTA objects to a gradual phase in of the reduced draws resulting from the implementation of the $36 threshold level, arguing such a gradual phase in unsound from a policy standpoint and is legally insufficient. CCTA argues that a gradual phase in is unjustified because it prolongs the status quo subsidy system which CCTA believes to be inequitable to competitors. CCTA argues that no phase-in is necessary because each COLR can profitably provide service in areas with line costs up to the $36 threshold level without B-Fund support by raising rates for services marketed to customers other than basic service.

CCTA further argues that a gradual phase in of the new benchmark would likely be considered illegal based on its characterization of the phase in as "the use of public funds for a private-not public-purpose." (CCTA Comments at 6). CCTA argues that by extending the transition to the $36 threshold through a phase-in period, the Commission would be engaging in a "give away" of public funds authorized by the legislature for the purpose of addressing universal service goals.¹²⁸

We find no merit in CCTA's objections to the gradual phase-in of the $36 threshold either on public policy or legal grounds. In carrying out our responsibilities to administer and reform the B-Fund program, we must weigh and balance various conflicting interests. A necessary element of this weighing and balancing process involves Commission determinations as to the timing of the transition for implementing changes to the high-cost threshold and resulting draws from the fund. As a basis for requiring the transition to occur in a phased manner, we conclude that each discrete change in the threshold level constitutes an appropriate basis for subsidy draws at that point in time. We make such determination within the bounds of our discretion as delegated by the Legislature pursuant to § 739.3 (c). The mere fact that CCTA disagrees with the Commission's discretionary judgment as to the proper timing of the transition process is no basis for a claim that B-Fund draws constitute a "gift" to a COLR. Rather, the phased implementation provides for an orderly process for transitioning the allocation of universal service funds rather than by an abrupt change.

We further conclude that there is no necessity to authorize any offsetting rate increases to preserve revenue neutrality as a result of reducing B-Fund support levels as implemented in this order. In D.06-08-030, we identified only one remaining area where revenue neutrality principles would apply during the transition period until full pricing flexibility takes effect. Specifically, we stated: "the ILECs may apply the revenue neutrality principle during the transition period in order to offset Commission-mandated price changes in services still subject to price controls." We view this requirement as applying in a very narrow manner only to offsetting rate changes within the elements of basic service that are still subject to price controls. Thus, if one basic rate element were to be reduced, an offsetting increase would be made in another basic rate element to maintain a neutral result in overall basic rate revenue levels. That narrow application of revenue neutrality does not apply to circumstances here where we are authorizing systematic increases in basic service elements to transition toward full rate flexibility. Moreover, to the extent that we are increasing basic rates over all, any offset for revenue neutrality would involve a reduction in revenues. In any event, as explained below, any attempt to calculate a revenue neutrality adjustment would be virtually impossible in today's regulatory environment, particularly given all of the different discount plans that have been put in place over the past decade. Therefore, consistent with D.06-08-030, there is no basis to invoke revenue neutrality in response to any changes being implemented in this order and consequently there is no need to delay implementation of the revised benchmark until full pricing flexibility for basic rates takes effect.

We find inapplicable AT&T's argument that "[t]he principle of revenue neutrality should be applied, as it has been applied to other Commission-ordered changes in rates since the inception of NRF."¹²⁹ AT&T references the Commission's "consistent" and "repeated" historical rate rebalancing under NRF (our pre-URF price cap regime) as a model to apply in this proceeding.¹³⁰ In this regard, AT&T references D.04-12-022 which states:

We find in past instances in which the Commission has ordered rates to be reduced we have provided for revenue neutrality. We are wary of midstream changes to our regulatory programs, which have been crafted with an eye toward balancing competing interests. We could only depart from the established policy with a compelling showing.¹³¹

This quotation was in the context of the now defunct regulatory framework under NRF. The "regulatory programs" from which a "midstream change" was suspect, as referenced in D.04-12-022, however, are now virtually nonexistent with the adoption of URF in D.06-08-030.

We concluded in D.06-08-030 that "[t]here is no longer a need for the NRF regulatory apparatus of price caps, annual price cap filings, productivity factors, and all residual elements of rate-of-return regulation, including the calculation of shareable earnings."¹³² The concept of "revenue neutrality" was a residual element of the era of rate-of-return and NRF regulation, to ensure that regulatory changes did not adversely affect the ILEC's financial viability or cause unwarranted windfalls.

When the B-Fund was established in 1996, we determined that "in order to make subsidies for high cost areas explicit, there must be a correlating downward adjustment of rates or price caps through a surcredit or reduction in tariffed rates or price caps so as to prevent the ILECs from recovering implicit subsidy support as well."¹³³ We initially implemented this downward adjustment as a billing surcredit as an equal percentage rate reduction on all services except residential service and contract rates. Pacific Bell filed an application to replace the surcredits with specific reductions directly to different services, which we approved in D.98-07-033.¹³⁴

In D.98-07-033, in reducing price ceilings to offset the explicit B-Fund subsidies, we stated: "By reducing Pacific's authorized price ceilings for these services, we ensure that Pacific cannot unilaterally raise these prices, thereby negating or redirecting our adopted offset; Pacific must file an application to raise its service price ceilings." D.98-07-033 made no changes to basic service rates.

With the adoption of URF in D.06-08-030, however, price ceilings (other than for basic service) have been completely eliminated. The URF ILECs are no longer required to file an application to raise prices for these services. URF ILECs may now simply file one-day effective advice letters but must give consumers 30 days' notice of rate increases and more restrictive terms and conditions. Those tariffs may be challenged. Other previous restrictions on the ILECs' ability to adjust rates for services other than basic residential service, however, have been eliminated.¹³⁵ The opportunity to adjust rate levels based upon competitive market forces provides a ready vehicle through which reduced B-Fund subsidies can be offset. The ILECs could in fact have already "rebalanced" their rates, at least partially, in anticipation of a reduction in
B-Fund support levels. In this regard, we note that since September 2006, the ILECs have already implemented significant price increases for various residential services which are not subject to the basic residential rate freeze. These increases are summarized in Appendix Table 2 of this Decision. To the extent that these price increases have already compensated the COLR for higher costs, any additional "revenue neutrality" adjustment, even if not otherwise unjustified, would be a windfall.¹³⁶ In the environment under URF as adopted in D.06-08-030 where the COLR is subject to competitive market forces, the principles that once justified revenue neutrality are moot.

At the time CHCF-B program was established, residential telecommunications services consisted largely of basic service, vertical features, and toll. Since then, additional services such as all distance, VoIP, high-speed internet, wireless services, and multi-channel video services are typically offered as a "bundle." Although the rate freeze continues on basic service through January 1, 2009, the COLR can still adjust the price of service bundles which include provision of a primary residential line. As previously noted, the ILECs claim that two-thirds or more of their customers subscribed to service bundles (the proportion depends in part on the definition of bundles). AT&T estimated that, as of July 2006, only 10.8% of its billed residential figures were exclusively for basic service only without some additional bundled AT&T or AT&T affiliate service.¹³⁷ In many cases, these services are offered to customers in high cost areas as part of a bundle which includes basic service.

Therefore, the COLR may be able to compensate for reductions in subsidy support from the customer in the high cost areas by adjusting the prices of service bundles. The ILECs argue that such an approach would conflict with our policy against implicit cross-subsidization of services. There is no evidence in the record that any cross-subsidization would occur in the short-term until January 1, 2009, or at any point thereafter. To the extent that a carrier may increase prices for service bundles to offset the loss of subsidy support, such prices increases could not apply to the basic service component. Further, any such restrictions will only be transitory, however, until the rate freeze is lifted and carriers have the first opportunity to exercise full pricing flexibility for basic services. Moreover, as noted above, a large majority of residential customers subscribe to bundles of services delivered over the primary access line. To the extent that the customer pays a single bill for the entire package of bundled services, any price increase would apply to the total bundle. Irrespective of which particular services were attributed with any increase within the bundle, therefore, the customer's total charge would be the same.

We also reject AT&T's argument that it could not succeed in reflecting the true cost of lines in high cost areas through bundled service offerings because the bundled price would not be competitive.¹³⁸ AT&T offers no empirical data concerning how, or at what point, its overall price for service bundles become uncompetitive. On the other hand, in D.06-08-030, we found that competition exists throughout the ILECs' service territory. Therefore, in addition, trying to impose revenue neutrality would create an unequal competitive advantage, contrary to URF as adopted in D.06-08-030. Competitors other than ILECs already have price flexibility for all services, including basic residential lines, and revenue neutrality has no applicability or relevance.¹³⁹ Competitors that offer basic service as part of a bundle receive no B-Fund support, but still recover sufficient revenues to induce them to compete with the ILECs. Moreover, we have already concluded that basic service costs above a threshold of $36 per line would continue to receive B-Fund support so as to meet universal service goals. Of course, any actual price increase for a service bundle that AT&T might charge would be constrained by features and prices for service bundles offered by competitors.

In any event, the COLR will not be competitively disadvantaged relative to other service providers who already have to compete against the COLR's allegedly subsidized basic rate, but without any B-Fund subsidy. Given these considerations, we conclude that the approach we adopt herein is fair and consistent with our overall procompetitive framework adopted in D.06-08-030.

Another reason why revenue neutrality is an inappropriate policy is because there would be no practical way to determine specific rate adjustments to ensure a truly revenue-neutral result. AT&T acknowledges that it would be virtually impossible to account for all revenue differences attributable to rates that have changed for competitive reasons since rate rebalancing was instituted in 1998, given the different discount plans that have been put in place and replaced since then. Also, competition radically affected AT&T's customer base, both in access lines and minutes of use. AT&T concedes that whether its rates actually decreased or increased and what revenue effects resulted are, at best, not simple questions to answer.¹⁴⁰

The Commission has not required revenue neutrality and rate rebalancing when revenues increased because AT&T raised prices. It would be untenable to order rate increases in the name of revenue neutrality without reconciling changes in rates over the past eight years. Such an approach would run the risk of implicitly compensating the ILEC for competitively motivated revenue decreases, which would be unfair and detrimental to consumers. The COLRs have utterly failed to provide any detail that would even allow us to consider such an approach. Mere allegations that changes to carrier costs have occurred since the most recent review are not enough. Under the regulatory frameworks in place over the past eight years, carriers have had ample opportunity make a case for changes to the basic service rates, and to the extent any pricing limitations continue, existing processes are available for them to present information that would merit a change.

We also disagree with AT&T's claim that "[f]ederal law also requires revenue neutrality."¹⁴¹ AT&T argues that Section 254 of the 1996 Act requires "specific, predictable and sufficient Federal and State mechanisms to preserve and advance universal service." AT&T argues that reducing the CHCF-B Fund without also providing for an alternative revenue offset contravenes the Act because it would reduce a revenue source that was specifically created to preserve universal service.¹⁴² Contrary to AT&T's claims, we find nothing in Section 254 that requires "revenue neutrality." The reforms that we adopt are fully consistent with the goals of Section 254 to "preserve and advance universal service."

We also reject AT&T's argument that it would constitute an impermissible "takings" to reduce subsidy support levels without providing an offsetting increase in basic rates. As previously explained, AT&T has ample opportunities to exercise price flexibility under URF through the offering of bundled services which include provision of a basic residential line. Moreover, to the extent that we reduce the level of B-Fund support available to AT&T to cover the cost of residential basic service, such funds are not an entitlement. AT&T and the other COLRs have no entitlement to continue receiving high cost support. AT&T fails to provide any justification as to how a "takings" would result from any actions we adopt in this order to reform the B-Fund program and to target support in a more efficient manner.

AT&T posits that the Constitution of the United States is implicated by making changes to the B-Fund, and not allowing full pricing flexibility immediately for basic service rates.¹⁴³ We reject this claim as lacking facts or evidence to support it. AT&T's only claim to colorability is that the Sixth Circuit decision in Michigan Bell Tel. Co. v. Engler¹⁴⁴ is somehow controlling here. However, the circumstances set forth in Engler do not apply here, even if it were the law of the Ninth Circuit in which California is located.

In Engler, on a facial challenge to a Michigan statute, the Sixth Circuit held that it would be unconstitutional for a government to prevent a utility company from collecting a constitutionally reasonable rate of return on its investments.¹⁴⁵ AT&T tries to leverage this basic tenet of utility regulation to require the Commission to remove all price controls on its telecommunication services. AT&T makes a number of legal and factual leaps in making its argument.

AT&T inappropriately argues that by choosing not to regulate the pricing of most telecommunication services that we are requiring the subsidization of regulated service "with income from rates either deemed to be competitive, or with revenues generated from unregulated services."¹⁴⁶ The cases cited by Engler as the basis for this premise dealt with requiring different lines of business from subsidizing the regulated business, facts not in accord with the facts at issue here. Further, the basic premise of those cases dealt with requiring a company to operate a regulated business at a loss or threaten the solvency of the company. There is no evidence in the record that AT&T or any of the other ILECs are operating their regulated businesses at a loss or that the solvency of their companies is at issue.

As an initial matter, we have never looked at basic residential service as a separate regulated business that must bear all the costs of the telephone network,¹⁴⁷ and decline to do so here. In fact, the decisions establishing the current basic rates -- which for the affected companies are all more than ten years old and some underlying general rate cases are almost twenty years old, all preceding the Telecommunications Act of 1996 which mandated competition for local telephone service -- explicitly established the basic residential rate at "one half of [fully allocated costs]."¹⁴⁸ This practice recognized that some of the telephone network plant costs should be recovered in rates for services other than the basic exchange rate. This practice recognized the inherent sharing of the network by many regulated services; it would not be reasonable to place the entire cost of the local loop and switch in the basic subscriber's monthly rate.¹⁴⁹ Yet, AT&T would have us undo this decades old precedent because we have allowed them substantial pricing flexibility in D.06-08-030, while retaining a freeze on the basic residential rate until January 1, 2009 consistent with state law. At the core of AT&T's takings argument is the assumption that by removing the pricing regulation on some services, we must remove the pricing regulation on all services or else we are guilty of a taking of its property.

Such a result is absurd. Assuming arguendo such a result had merit, the remedies are simple: either we reregulate those price elements that were granted pricing flexibility in D.06-08-030, or AT&T can file a general rate case to determine the proper pricing of its basic service. We decline to do the former or order the latter here. Further AT&T has not chosen to voluntarily file a rate case as to its basic service to date. If, however, AT&T or any of the other affected ILECs believe that the regulations adopted in D.06-08-030 or in this decision somehow threaten their solvency, they retain the ability to correct the situation by simply filing for a rate case that would allow an adjustment to the few rates where we have retained any price controls. In this way it can be ensured that no constitutional taking will ever occur.¹⁵⁰ Of course, if AT&T had any proof that its rates were capped at a level that would result in such a claim, it would have filed to adjust those rates many years ago. Accordingly, we find no merit to AT&T's argument that our actions in this decision constitute an unconstitutional taking.

Further, the cross subsidy argument relating to basic service being subsidized by other non-rate regulated telecommunications services such as voicemail, call features, Caller ID and the like, are particularly ironic. AT&T itself argued for complete rate flexibility in our URF proceeding which resulted in D.06-08-030. AT&T was largely successful in its argument, as most telecommunications services were released from regulation in that decision given the state of competition. Indeed, it is a matter of public record that AT&T has taken advantage of its rate flexibility by filing one day effective advice letters increasing many non basic rates. Further, AT&T was an active participant advocating the passage of the DIVCA, where AT&T won the right to provide statewide video services but accepted a freeze placed on the ILEC's basic rate until January 1, 2009 by the state Legislature. Given its active role in both URF and DIVCA, bringing AT&T to its desired position of having very few regulated rates and a new line of video services, we find it ironic that AT&T would be making outdated arguments for revenue neutrality and "takings" of revenue that are appropriate for a bygone regulatory era where cost of service regulation reigned.

Taken together, the elements of D.06-08-030, DIVCA, and this decision remove any plausible basis for AT&T's takings argument because the "total effect" of the Commission's actions is not, in fact, confiscatory.¹⁵¹

¹²¹ AT&T Opening Comments at 21-22; SureWest Opening Comments at 12; Verizon Opening Comments at 14-15. Frontier Opening Comments at 9.

¹²² AT&T Opening Comments at 20.

¹²³ AT&T Opening Comments at 20-21 (citing Re Intrastate Carrier Access Charges, Decision No. 04-12-022, Interim Opinion Resolving Intrastate Access Charge Policy Questions in Phase I, mimeo., p. 10 (Dec. 2, 2004)).

¹²⁴ Cox Opening Comments at 14; Sprint Nextel Opening Comments at 2; Time-Warner Opening Comments at 15-17; and TURN Opening Comments at 9-11.

¹²⁵ DRA Opening Comments at 27-29; Cox Opening Comments at 14; Sprint Nextel Opening Comments at 2; Time-Warner Opening Comments at 15-17, and TURN Opening Comments at 9-11.

¹²⁶ As a limited exception, AT&T does not have the freedom to raise switched access prices. Switched access was one of the services receiving price reductions as a result of the revenue-neutral rate rebalancing adopted for AT&T in D.98-07-033.

¹²⁷ Verizon Opening Comments at 10-11.

¹²⁸ As a basis for this claim, CCTA makes reference to the clause of the California Constitution (Article XVI, § 6, which prohibits gifting public funds, that is, "appropriations of public money for which there is no authority or enforceable claim, even if there is a moral or equitable obligation."

¹²⁹ AT&T Opening Comments at 21.

¹³⁰ AT&T Opening Comments at 19-20.

¹³¹ D.04-12-022, mimeo. at 10.

¹³² D.06-08-030, mimeo. at 272, COL 115.

¹³³ D.96-10-066 at 207.

¹³⁴ 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.

¹³⁵ The limited exception is that AT&T does not have the freedom to raise switched access prices. Switched access was one of the services receiving price reductions as a result of the revenue-neutral rate rebalancing adopted for AT&T in D.98-07-033.

¹³⁶ A Commission-enforced rate rebalancing, imposed on the ILECs' customers who are most likely to be vulnerable to price increases, could be used by the ILECs to underprice competitive services.

¹³⁷ AT&T Response to DRA Data Request 1-19, part f.

¹³⁸ AT&T Comments, p. 8.

¹³⁹ See Cox Opening Comments at 14-15; Sprint Nextel Opening Comments at 2; Time-Warner Opening Comments at 15-17.

¹⁴⁰ AT&T Opening Comments at 24.

¹⁴¹ AT&T Opening Comments at 21.

¹⁴² AT&T Opening Comments at 21.

¹⁴³ AT&T Comments on the Proposed Decision at 21.

¹⁴⁴ Michigan Bell Tel. Co. v. Engler, 257 F.3d 587, 593 (6th Cir. 2001).

¹⁴⁵ Id.

¹⁴⁶ Id. at 594 (citing Brooks Scanlon Co. v. Railroad Commission, 251 U.S. 396 (1920); Calfarm Ins. Co. v. Deukmejian, 771 P.2d 1247, 1254).

¹⁴⁷ D.89-10-032, D.94-09-065.

¹⁴⁸ D.94-09-065.

¹⁴⁹ D.89-10-032, D.94-01-065.

¹⁵⁰ Babbitt v. United Farm Workers Nat'l Union, 442 U.S. 289, 306 (1979), City of Houston v. Hill, 482 U.S. 451, 468 (1987) (quoting Harman v. Forssenius, 380 U.S. 528, 534-35 (1965)) (courts may avoid adjudicating the federal issues involved where the state action may be interpreted to "render unnecessary or substantially modify the federal constitutional question.")

¹⁵¹ Duquesne Light Co. v. Barasch, 488 U.S. 299, 315 (1989).