9. Disposition of Rate Freeze on Basic Residential Service

In crafting changes to the B-Fund, and the associated implementation time table, we must consider when and how the existing freeze on basic rates shall be lifted. We granted pricing flexibility for all services in D.06-08-030 in the URF proceeding, except for basic residential local exchange service. We set an automatic expiration date of January 1, 2009, for the freeze on basic residential local exchange rates not subject to a B-Fund subsidy, coinciding with the scheduled sunset of the provisions of § 739.3.¹⁵⁴

D.06-08-030 (p. 2) states: [W]e cap the price of basic residential service until January 1, 2009 in order to address the statutorily-mandated link between the LifeLine rate and basic residential service rates."¹⁵⁵ We further stated that: "After January 1, 2009, the cap on basic residential service rates that are not subsidized by CHCF-B will no longer serve the public interest, and accordingly, the cap will sunset automatically with no further Commission action required." (D.06-08-030 at 152.)

We deferred to this proceeding, however, the disposition of the rate freeze for residential services, if any, that remain subject to CHCF-B subsidies. In this respect, we ordered that "basic residential services receiving a CHCF-B subsidy shall be frozen at a level equal to the current rate, which will be reevaluated in our upcoming CHCF-B review in R.06-06-028." (D.06-08-030 at 143.) By ruling dated February 23, 2007, we provided notice and opportunity for comment as to whether, in what manner, or to what extent, the rate freeze applicable to basic residential services should be lifted and/or modified as a function of revisions to the B-Fund mechanism contemplated in this OIR. We consider this issue below.

9.1 Parties' Positions

AT&T supports the lifting of the freeze on all basic rates effective January 1, 2009, but argues that both the B-Fund subsidies and revenue neutrality would still be warranted even after full pricing flexibility takes effect. AT&T asserts that if the support for high cost lines is reduced while the COLR obligation remains, any changes to the support level would have to be made up on a revenue neutral basis. AT&T does not believe that full pricing flexibility for basic would eliminate the need for support. Rather, the subsidy level would merely be adjusted to reflect whatever rate level was set for basic service.¹⁵⁶

AT&T proposes that any reduction in B-Fund support levels associated with changes in the benchmark or "presumed rate" be phased in over an extended period. AT&T states that the precise time period for such a phase-in would depend on the magnitude of the total increase in the benchmark threshold adopted by the Commission, but suggests that a phase-in limited to a $2 per year would be manageable.¹⁵⁷ AT&T argues that the Commission cannot set a presumed rate two or three times higher than what a carrier has been allowed to charge because "rate shock" would result with negative consequences for consumers.

SureWest advocates a multi-year transition period for purposes of implementing increases to basic rates to a level closer to the actual cost of service, with a corresponding gradual reduction in B-Fund draws. SureWest agrees with AT&T that given the current disparity between costs of service and basic rate levels, any rate increase implemented on a "flash cut" basis to recover full costs could result in "rate shock."

Sprint argues, however, that any risk of sudden rate increases to make up for reductions in B-Fund subsidies would be significantly moderated by competition. Rather than sudden rate increases, Sprint/Nextel argues that the more likely scenario is that given competitive market forces, the ILEC would continue to price basic service at a level that would induce the customer to remain with the ILEC.

DRA argues that if the B-Fund program is to continue beyond January 1, 2009, in some form, the Commission should require the COLR to maintain price caps as a condition of receiving subsidy funds. DRA argues that absent price caps on basic service, there would be no assurance that customers benefited from B-Fund subsidies because the COLR could negate any benefits by raising prices for basic service. As an alternative to immediate elimination of the B-Fund, DRA proposes a multi-year phase-out period, with a "stepping down" of the current per-line subsidy each year until the full subsidy is eliminated. DRA specifically recommends a three-year period for phasing in any permitted rate increases for AT&T's basic residential service before establishing a single statewide benchmark for affordable service.¹⁵⁸

TURN argues that pursuant to Pub. Util. Code § 454, the rates for rural customers cannot be increased absent a showing that such increase would be "just and reasonable." TURN thus argues that continuation of a rate cap should be required until the Commission conducts an appropriate investigation. As an additional reason to continue the rate freeze, TURN argues that Pub. Util. Code § 5940, prohibits cross-subsidies between stand-alone residential primary lines and deployment of a video service network. TURN argues that if the rate freeze is lifted, the Commission would have no way to assure itself that rate increases to rural residential primary lines were not being used to finance the video network. TURN argues that an extended rate freeze would be warranted to ensure that the provisions of § 5940 are being enforced.

9.2 Discussion

We first consider whether the existing rate freeze can or should be lifted prior to January 1, 2009. Although D.06-08-030 contemplated a rate freeze continuation until January 1, 2009, the DIVCA permits inflation-related adjustments to basic rates prior to January 1, 2009.¹⁵⁹

In this regard, Sec. 5950 of the Pub. Util. Code states:

The Commission shall not permit a telephone corporation that is providing video service ...pursuant to a state-issued franchise as an [ILEC] to increase rates for residential, primary line, basic service above the rate as of July 1, 2006, until January 1, 2009, unless that telephone corporation is regulated under rate of return regulation. However, the commission may allow rate increases to reflect increases in inflation as shown in the Consumer Price Index published by the Bureau of Labor Statistics.

Consistent with this statutory provision, we authorize an increase in basic rate caps for AT&T and Verizon effective January 1, 2008 equal to the Consumer Price Index (CPI) rate of inflation. Since rate increases for basic service prior to January 1, 2009 are limited to the rate of inflation, we shall not authorize any additional rate increases before that date. In comments on the Proposed Decision, DRA proposes use of the "CPI-U," which represents the broadest of the CPI measures, as a basis for calculating the amount of increase. We agree that use of the CPI-U is a reasonable basis for the rate increase effective January 1, 2008. 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 resulting rate increase for each ILEC effective January 1, 2008 is 2.36%. We authorize AT&T and Verizon to file advice letters to implement rate increases to become effective January 1, 2008, consistent with this directive. The authorized increase shall constitute a cap on basic rates. Therefore, the ILEC may elect to charge less than the capped amount, but may not charge more.

Although the basic rate freeze will end on January 1, 2008, we conclude that it would be premature to grant full pricing flexibility for all basic rates immediately. While we recognize the need to start the process to enable basic rates to move closer to costs, we also share the concerns of certain parties as to the potential for retail "rate shock" if full pricing flexibility for basic rates were granted immediately. We believe that cost-based rates for basic service should be implemented gradually to provide for a smoother transition for customers. Therefore, we shall adopt a phased-in schedule to take effect beginning January 1, 2008, to begin transitioning from the current basic rate levels toward the goal of cost-based rates, as disciplined by competitive market forces. During this phase-in period, we shall impose caps on the maximum level that the COLR may charge for basic service, subject to gradual step increases over a prescribed time period until the rate cap rises to a level to be determined in Phase II. In this manner, any potential "rate shock" will be avoided.

In comments on the PD, certain parties seek clarification on whether the phase-in provisions for the rate cap on basic service is to apply only to lines subject to the B-Fund subsidy or to all basic service lines. They believe that certain portions of D.06-08-030 appear to indicate that the transition to full pricing flexibility was to be implemented differently for lines subject to B-Fund subsidies versus other lines. We hereby clarify that the phase-in provisions of the basic service cap that we adopt herein are intended to apply to all basic service lines served by the COLR, not just those which are subject to the B-Fund subsidy. If the rate caps were to apply only to lines subject to the B-Fund, but not to other basic lines, unintended consequences could result. For example, under such a scenario, the COLR could increase rates for basic lines in urban areas to levels exceeding those which could be charged in designated "high-cost" areas. Instead, applying a uniform rate cap to all basic lines will produce a more coherent transition implementation process.

We shall thus develop a further record in the next phase of this proceeding concerning the appropriate time period and magnitude of subsequent step increases that should be authorized after January 1, 2009, for COLRs to transition from the current subsidized basic rate levels up to a target cap. We shall adopt a specific schedule for the phase-in of step increases in basic rate levels to take effect by the time that the rate freeze expires on January 1, 2009. After the phase-in period has concluded, we shall authorize full pricing flexibility for basic rates.

After full pricing flexibility takes effect, all carriers, including the COLR will be free to adjust prices for residential rates based on competitive market forces rather than based upon whether a subsidy is available to support prices below their cost. Carriers will be able to price residential service to reflect costs in a particular geographic location rather than applying a uniform system average price. A requirement of geographically averaged prices could encourage the provision of services by high costing but subsidized technologies, while discouraging service by competitors offering lower-costing but unsubsidized services. As an example, in many rural areas, it may prove less expensive to provide basic telephone service via wireless technologies than by subsidizing the construction of long copper wire traditional telephone service connections.

AT&T offset its B-Fund subsidy by directly reducing services other than for basic rates. To offset their B-Fund subsidies, Frontier and Verizon each apply a B-Fund surcredit to their customers' bills for all intrastate services except basic residential service.¹⁶⁰ Frontier and Verizon propose that any reduction in subsidies be offset by a reduction in the B-Fund surcredit.¹⁶¹ DRA recommends that the "permanent" surcredits adopted for Frontier and Verizon in Resolutions T-17008 and T-17009, respectively, be eliminated.¹⁶² We shall phase out these surcredits in a series of steps in tandem with the schedule for revisions to the benchmark and corresponding reductions in B-Fund draws. The phase-out of the surcredits will be conducive to the goal of moving more toward reliance on competitive forces rather than subsidies to meet universal service goals.

The lifting of the rate freeze is consistent with the URF policies adopted in D.06-08-030, and will facilitate the goal of moving rates for basic service toward a level that reflects actual costs. Particularly considering the extended period that has transpired without adjusting basic rates to respond to changing costs, the freeze should be lifted as directed herein. In that manner, basic rates can begin to move closer to their true costs, consistent with a competitive market.

California's basic residential telephone service rates are priced among the lowest in the nation. Consistent with a competitive market, increases in the price of basic service to align more closely with actual costs would send a more economically efficient price signal to customers. We disagree with Sprint's observation, however, that the forces of competition should act as a constraint to mitigate concerns regarding any claimed "rate shock" as a result of immediately lifting the freeze on basic residential rates. Although the voice market is competitive, basic residential rates have not been priced based upon competitive market forces but have remained frozen for an extended time. Therefore, we believe that a transitional period is needed to move smoothly from the current price freeze to a pricing structure more reflective of a competitive environment.

TURN argues that lifting the freeze on basic rates could result in cross-subsidization between basic local exchange service and video services in violation of § 5940. In comments on the Proposed Decision, AT&T and Verizon object to addressing the need for additional safeguards or reporting requirements to detect and prevent cross-subsidization of video services, claiming that the Commission addressed this issue in D.07-03-014. In that decision, we stated that existing "measures, imposed by both the federal and state government, obviate the need for additional rules to prevent financing of video deployment with rate increases for stand-alone, residential primary lines, basic telephone services." (D.07-03-014 at 187.)

The Commission found in D.07-03-014 that "[i]t will be relatively easy to review any changes to rates of stand-alone, residential, primary line basic telephone service, either prospectively or retrospectively, to ensure that the increase is not used to finance video deployment." Further, a formal investigation into alleged illegal cross-subsidization may be initiated by the Commission at any time,¹⁶³ and any entity or person may bring cross-subsidization complaints to the Commission.¹⁶⁴ There is no basis to consider additional reporting requirements or other safeguards to guard against cross-subsidization of video services as prohibited under § 5940.

We also disagree with TURN's argument that the requirements of Pub. Util. Code § 454 require formal Commission approval based on a separate showing that the increase is "just and reasonable." Pursuant to D.06-08-030, we have determined that competitive market forces will assure that rate levels are "just and reasonable." No separate showing will be required as a basis to adjust basic rates.

We also note that, to the extent that basic service rates change due to the lifting of the freeze, the rates that Small Local Exchange Carriers (LECs) charge would likewise be affected as a result. Small LECs' rates would be affected because the average local exchange rates of the Small LECs are not to exceed 150% of comparable California urban rates. The 150% level constitutes a benchmark against which specific company rate designs are measured than a rigid requirement that each rate design element be set at 150% of the underlying urban rate. Small LECs that cannot meet their revenue requirement as a result of the 150% rate level limitation are eligible to draw from the CHCF-A. The lifting of the rate freeze on January 1, 2009 will cause changes in the comparable California urban rate levels for purposes of the 150% cap. We shall consider any applicable implications for the CHCF-A as a result of the lifting of the rate freeze, along with more general review of the CHCF-A program, in a separate proceeding.¹⁶⁵

As noted in D.06-08-030: "We emphasize that application of the revenue neutrality measure will end on January 1, 2009, when we lift the basic residential rate price cap on services not subsidized by CHCF-B." Therefore, with the lifting of any remaining price freeze on January 1, 2009, there will no longer be a basis for the Commission to maintain revenue neutrality or to mandate price adjustments associated with reductions in B-Fund support levels.

Although we shall lift the freeze on all basic rates for AT&T and Verizon effective January 1, 2008, we conclude that the B-Fund subsidy program should continue beyond January 1, 2008, albeit at a reduced level of support for certain high cost lines in more targeted high cost areas. In the interests of ensuring that universal service goals continue to be met, certain truly high cost areas will still require some level of B-Fund support to keep rates at reasonably comparable levels with those of urban areas. The COLR needs to offer service to such areas even though the costs of service remain high. Targeted support from the B-Fund will provide a continuing vehicle to fund the gap between rate levels and service costs in such areas.

We shall conduct a cost study, as explained below, to update the proxies for high cost areas so that the level of support is set at a reasonable level. Subject to the rate cap phase-in, to be determined in the next phase of this proceeding, the COLR will have the flexibility to charge rates subject to competitive market forces.

As a basis to receive B-Fund support after full pricing flexibility takes effect, however, we shall require that a COLR certify annually that it is not charging rates for basic service in excess of the benchmark levels that we establish herein. A COLR that does not make the required annual certification will be required to provide a detailed showing as to why it is unable to comply with the Commission's Orders. The Commission will evaluate the evidence and determine what, if any, action is required.

¹⁵⁴ D.06-08-030 (Conclusion of Law (COL) 30) states: "The Commission should maintain price caps on basic residential flat service, basic residential measured service, LifeLine basic residential service and Lifeline connection service until January 1, 2009 as discussed herein."

¹⁵⁵ The relationship between the basic residential rates and funding needed to support LifeLine is being addressed in the Universal Service, Public Policy Programs Rulemaking (R.06-05-028). LifeLine is a critical element in our universal service program to bring local telephone service at affordable rates to low income Californians, and any changes to basic residential rates must be consistent with LifeLine policies being addressed in R.06-05-028. We intend to resolve relevant LifeLine issues in
R.06-05-028 in time to permit the lifting of the basic rate freeze effective January 1, 2009.

¹⁵⁶ AT&T Opening Comments at 22.

¹⁵⁷ AT&T Comments of 4/27/07 at 18.

¹⁵⁸ DRA Comments of 4/27/07 at 10.

¹⁵⁹ This provision of DIVCA applies only to carriers that obtain a statewide video franchise. AT&T, Verizon, and Cox have all sought such franchises. AT&T and Verizon's applications have been granted.

¹⁶⁰ Frontier Opening Comments at 3; Verizon Opening Comments at 15.

¹⁶¹ Frontier Opening Comments at 8; Verizon Opening Comments at 15.

¹⁶² DRA Opening Comments at 6.

¹⁶³ Id. at § 5890(g); Id. at § 798.

¹⁶⁴ Rule 4.1 of the Commission's Rules of Practice and Procedure ("A complaint may be filed by any corporation or person, chamber of commerce, board of trade, labor organization, or any civic, commercial, mercantile, traffic, agricultural or manufacturing association or organization, or any body politic or municipal corporation, setting forth any act or thing done or omitted to be done by any public utility including any rule or charge heretofore established or fixed by or for any public utility, in violation, or claimed to be in violation, of any provision of law or of any order or rule of the Commission.").

¹⁶⁵ See D.91-09-042, Appendix, 41 CPUC 2d, 326, 330.