6. Should the Commission Adopt Replacement Funding for the EAS Revenues Roseville Receives from Pacific?

6.1. Roseville's Position

Roseville asserts the Commission must replace the EAS payment that it now receives from Pacific. As the Commission itself stated when it approved Roseville's annual revenue requirement and rate design in Roseville's last GRC, the $11.5 million payment is used to pay for a significant portion of Roseville's cost of doing business to serve utility customers. In Roseville's most recent GRC decision (D.96-12-074), the Commission approved Roseville's NRF start-up revenues to recover its revenue requirement and indicated that the annual payments from Pacific should be used as a source for recovering Roseville's costs to provide utility service. According to Roseville, if the $11.5 million annual payment had not been available to Roseville, the Commission would have been required to fund that amount in another way (e.g., through external funding support or increased rates) to cover the NRF start-up revenue requirement that the Commission determined was necessary for Roseville to provide utility services.

Furthermore, Roseville states, the Commission was aware that the $11.5 million payment would eventually end and included language in the GRC decision describing the possible scenarios for replacing the payment. The Commission contemplated that replacement funding might be accomplished through a universal service funding mechanism or rate rebalancing. (D. 96-12-074 at 151.) Explicit in the GRC decision's discussion is the principle that some form of revenue replacement must occur in the absence of the $11.5 million payment from Pacific to Roseville.

In Roseville's last GRC, ORA proposed elimination of the EAS payment from Pacific to Roseville. The Commission rejected ORA's proposal. According to the Commission,

We disagree with ORA to the extent ORA argues these payments represent a subsidy to Roseville's ratepayers. Rather, there is a cost for providing EAS service between Pacific and Roseville. The historic determination of this cost is a net flow of funds from Pacific to Roseville. Pacific and Roseville have agreed to freeze these payments at the 1991 level until the parties agree to, or the Commission determines, a new payment level. (Id.)

Roseville asserts that because the Commission included the $11.5 million payment in Roseville's NRF start-up revenue requirement, the Commission must ensure that an adequate replacement exists before the payments are discontinued. A utility whose rates are regulated by a government agency is entitled to the opportunity to earn a reasonable rate of return. Bluefield Water Works Improvement Co. v. Public Service Common of West Virginia, 262 U.S. 679, 692-693 (1923); Federal Power Commission v. Hope Natural Gas Company, 320 U.S. 591 (1944); Duquesne Light Co. v. Barasch, 488 U.S. 299, 314-315 (1989). Utilities may not be required to charge a rate so unjust as to be confiscatory. If the rates adopted for a utility do not afford sufficient compensation, ". . . the State has taken the use of utility property without paying just compensation and so violated the Fifth and Fourteenth Amendments." Duquesne Light Co., supra, 488 U.S. at 307-308.

Roseville states the $11.5 million payment recovers approximately 15% of Roseville's state-regulated costs based on the cost levels adopted in the GRC decision. (Exh. 1C, p. 20, Direct Testimony of Gierczak for Roseville.) To demonstrate the significance of the $11.5 million to Roseville, that payment represents approximately 9% of Roseville's total revenue.

In addition, Roseville states that its recent sharing advice letter, Advice Letter No. 489, establishes that Roseville experienced a 10.53% rate of return in 1999. (Exhibit 2, p. 6, Rebuttal Testimony, Gierczak for Roseville.) Without the $11.5 million payment, Roseville's rate of return for 1999 would be less than 6% which is below Roseville's floor rate of return as established by the Commission in Roseville's NRF.

As demonstrated above, states Roseville, the $11.5 million payment from Pacific was an integral part of the Commission's rate design for Roseville. To simply eliminate $11.5 million of Roseville's revenue, without an alternate means of recovery would result in confiscatory rate levels and in turn lead to a taking of Roseville's property. To avoid this result, the Commission must provide Roseville with a substitute revenue source upon the elimination of the $11.5 million payment.

Roseville asserts the Commission should not embrace ORA's unconventional proposal that Roseville not be authorized to recover replacement revenues since it is a "financially healthy company." ORA's proposal would improperly alter the Commission's NRF policies. First, ORA cites evidence regarding revenues earned by Roseville's parent, Roseville Communications Company (RCC), in support of its position. However, such evidence is irrelevant to the determination of whether RTC has the opportunity earn a reasonable rate of return. Under the analysis required by the Supreme Court decisions, the obligation to ensure a utility has an opportunity to earn a reasonable rate of return extends only to those facilities needed to meet the utility's obligation to provide regulated services. D.96-09-089 [68 CPUC 2d 209, 224].) Consistent with this principle, the proper scope of the analysis regarding the adequacy of a utility's rate of return includes only those revenues obtained from regulated assets. (Id. at 225.) According to Roseville, the Commission should ignore ORA's discussion regarding the earnings of RTC's parent, RCC.

Second, states Roseville, without the annual $11.5 million EAS payment, Roseville's rate of return would fall to below 6%. Notwithstanding ORA's assertions, a rate of return below 6% due to a rate design adopted by the Commission yields an inadequate rate of return for Roseville and requires that the Commission authorize replacement revenues.

Third, ORA points to the recent audit of Roseville's non-regulated operations recently performed by ORA's consultant, which is currently under review in Roseville's NRF Review proceeding (A.99-03-025), as further evidence of Roseville's financial health. As Roseville discussed in its opening brief, Roseville extensively litigated the merits of those audit results. Accordingly, Roseville vigorously disputes any suggestion in this proceeding that Roseville will realize substantial shareable earnings in either 1999 or 2000 as referenced in ORA's opening brief. Furthermore, Roseville states that its Advice Letter No. 489 demonstrates that Roseville had no shareable earnings for 1999. The Commission has not ruled on the issues asserted in ORA's audit, and Roseville remains confident the Commission will find Roseville complied with applicable cost allocation requirements. ORA's contentions pertaining to Roseville's audit should be disregarded in this proceeding because they lack sufficient evidentiary foundation and are speculative.

Fourth, Roseville rebuts ORA's contention, based on Pacific's witness Peters' oral testimony regarding Sugarland Telephone Company (Sugarland), that Roseville has excessive costs and should not recover replacement revenues. According to Roseville, a comparison of Roseville to Sugarland lacks credibility given that a more appropriate comparison exists between other California LECs and Roseville. For example, Peters decided not to compare Citizens, which has comparable corporate operations costs to Roseville. Because Citizens is also located in California, with corporate offices in Sacramento, Citizens faces a similar operating environment from a regulatory perspective which might explain why a carrier in California has higher corporate operations costs than a carrier in Texas.

In addition, Roseville asserts Sugarland is listed as a utility receiving an excessive number of customer complaints by the Texas regulatory commission. Pacific's witness did not rebut or deny the evidence of Sugarland's deficient service quality. Roseville, in contrast, consistently meets or exceeds the Commission's General Order 133-B service quality standards. Instead of relying on a sketchy comparison to a Texas LEC, the Commission need look no further than its own decision in Roseville's GRC/NRF start-up proceeding, in which the Commission determined that Roseville's NRF start-up costs were reasonable.

Finally, Roseville contends ORA suggests Roseville should not recover replacement revenue because it is a different company from what it was when its GRC/NRF start-up was adopted. ORA's suggestion conflicts with the principles underlying NRF regulation. NRF places risk on the LEC and through earnings incentives expects that LECs will become more efficient than they would normally be under traditional rate of return regulation. As Gierczak noted in his rebuttal testimony,

One of the core principles of the NRF is that companies are to be provided a significant incentive to do all the good things that companies in the American economy will attempt to increase their profits, such as reduce costs, introduce new products, provide outstanding customer service, and so on. By contrast, Jarjoura is incorrect that its proposed confiscation of Roseville's revenues will induce Roseville and competing carriers to increase productivity and provide the services at competitive rates. (Jarjoura Testimony, page 3). Rather than a positive incentive, the message delivered by confiscation is that a company that achieves increased earnings will be penalized by having them taken away.

Roseville asserts that ORA's proposal to confiscate Roseville's revenues would force the Commission to drastically alter its NRF. Currently, NRF LECs bear the risk of under-performance in a given year balanced by the potential benefit of additional revenues in those years when they out-perform their established rate of return. For example, to experience the possible upside of NRF regulation, Roseville had to endure a down year in 1997 when it earned only 9.11 %. ORA's proposal to confiscate the $11.5 million EAS payment, in contrast, would require that Roseville bear the risk for under-performance while eliminating any benefits to Roseville when it out-performs its market rate of return. In effect, ORA's proposal would eliminate any incentive for Roseville to be efficient, and incentive is the centerpiece of the Commission's NRF.

6.2. ORA's Position

ORA recommends termination of the EAS arrangement between Pacific and Roseville without establishing any replacement funding. ORA states the Commission implemented NRF regulation in 1989 to create a regulatory approach that is more efficient than traditional rate-of-return regulation. The purpose of NRF regulation is to foster competition and to encourage telecommunications carriers to manage their operations in the most efficient manner.

ORA recommends no replacement funding be established because Roseville is a financially healthy company that can absorb the loss of $11.5 million. According to ORA, the evidence in the record shows that Roseville is a financially healthy company whose financial status has dramatically improved since its GRC.

ORA cites RCC's 1999 annual report, which says the company's operating revenues and income have grown tremendously in the last three years as follows:

A. Total Operating Revenues (Exh. 9., p. 36):

Year 1997 1998 1999

Amount $114.9 million $126.7 million $140.8 million

% increase

over prior year N/A 10% 11%

B. Total Net Income (Exh. 9, p. 36)

Year 1997 1998 1999

Amount $22.9 million $25.04 million $31.7 million

% increase

over prior year N/A 9% 26.7%

According to RCC's 1999 annual report, RTC's total operating revenues constituted approximately 80%, 80% and 83% of RCC's total operating revenues in 1997, 1998 and 1999 respectively. (Id.) More specifically, RTC's rate regulated revenues increased $10.7 million or 11% in 1999 compared to 1998. (Exh. 9, p. 30.) In 1998, its rate regulated revenues increased $5.8 million or 6% compared to 1997. (1 Tr. 84, Gierczak for Roseville.) Similarly, Roseville's access lines grew 7% from 1997 to 1998 and 5% from 1998 to 1999. (Id.; Exh. 9, p. 30; See also Exh. 24.) In the face of such a significant growth in revenues and net income, says ORA, there is no reasonable basis for Roseville to be entitled to continue receiving any EAS subsidy.

ORA rebuts Roseville's assertion in its testimony that the Commission must replace the $11.5 million through another permanent source of funding because the revenue was included in Roseville's start-up revenue requirement in 1996. ORA does not dispute that the EAS revenues were included in Roseville's initial revenue requirement. However, Roseville's revenues and income have significantly grown since the GRC. Roseville's financial situation is not the same as it was five years ago. Based on Roseville's current financial status, it should be able to absorb the loss of $11.5 million.

Furthermore, ORA asserts a Commission-mandated audit supports its contention that Roseville is a financially healthy company. Pursuant to Commission order, Overland Consulting audited Roseville's operations from 1997 through June of 1999.⁴ According to the audit results, Roseville's 1999 shareable earnings are estimated at $11.4 million. The shareable earnings for year 2000 are expected to exceed $14 million. (Exh. 19, p. 4, Jarjoura for ORA.)

More importantly, states ORA, the audit revealed that there was a severe cost misallocation problem with Roseville, which has directly impacted Roseville's regulated earnings and costs. The audit demonstrated that Roseville grossly overstated regulated expenses and over-allocated regulated revenues to its affiliates thereby lowering the overall regulated earnings. Pacific witness Peters also testified about Roseville's cost misallocation problem. He stated as follows:

It's really hard to figure out how they [Roseville] can spend that kind of money, or they're misallocating their costs and/or some of both. And it's just hard for me - - I have never come across a company in my 30 years in this business that has costs of this magnitude for this size of a company. . . You've got to come to a conclusion that either Roseville is the most inefficient company in the United States, the ORA's audit has just reached the tip of the iceberg. . . (1 R.T. 134, Peters for Pacific.)

ORA states that during the hearings in this proceeding, Peters testified in detail about how inefficient Roseville's operations are. Based on his comparison study of Roseville's costs to those of comparable companies in the United States, he stated that Roseville's costs are twice the costs of comparable companies in the United States. (Id. at 119.) He testified that Roseville's corporate operations expense was the highest in the country and that Roseville's plant expense was also unreasonably high in comparison to other companies comparable to Roseville. (Ibid.) Specifically, he compared Roseville to a Texas telephone company, Sugarland. Sugarland's operations are very similar to Roseville's in that it is located outside of a metropolitan area (Houston) and has local calling into the Houston area. Roseville is also located outside of a metropolitan area (Sacramento) and has local calling into the Sacramento area. The comparison study showed that Sugarland's corporate operations expense was $5.23 per loop per month compared to Roseville's cost of $12.50, which is more than twice that of Sugarland. (Id. at 120.) The study also showed that Sugarland's plant expenses per loop per month was $8.86 compared to Roseville's of $18.49. (Id. at 121.) Peters testified that Roseville's corporate expense is "the highest in the country by quite a bit." (Id. at 119.)

ORA shares Peters' sentiments and concurs with him that Roseville's costs are unreasonably high. As such, any replacement funding for EAS would only encourage Roseville to continue operating inefficiently to the harm of ratepayers.

In its Reply Brief, ORA asserts that Roseville mischaracterizes ORA's discussion of Roseville's shareable earnings as a "shareable earnings proposal." ORA recommends that the Commission eliminate the EAS arrangement without establishing any replacement funding for Roseville. In support of this recommendation, ORA pointed out Roseville's shareable earnings to highlight the fact that no replacement funding is warranted because Roseville is a financially healthy company. Thus, contrary to Roseville's assertion, ORA is not making a "shareable earnings proposal" in this proceeding.

ORA states it is not proposing that Roseville use its shareable earnings to replace the loss of its EAS revenues. However, if the Commission nonetheless determines that Roseville should be allowed replacement funding and considers Roseville's shareable earnings as a recovery method, ORA does not dispute that this recovery method could result in a permanent reduction of $11.5 million in revenues for Roseville. But the potential reduction of $11.5 million in revenues that could result for Roseville is still reasonable and appropriate given Roseville's strong financial stance. According to the results of the Overland Consulting audit, Roseville's earnings for 1998 and 1999 exceeded its sharing benchmark, and ORA projects that Roseville's earnings for year 2000 will also exceed the benchmark. Thus, says ORA, even if Roseville's shareable earnings are used to replace the EAS revenues, Roseville would not be financially harmed.

ORA's Reply Brief rebuts Roseville's assertion that ORA's shareable earnings proposal relies on "unproven assertions and claims." During the course of a five-day hearing in the NRF proceeding, where ORA and Roseville litigated Overland's audit findings, Overland provided overwhelming evidence which demonstrated that Roseville's earnings for the past two years have reached the sharing benchmark and therefore Roseville should have shared its revenues with ratepayers. According to ORA, Roseville did not even question the majority of Overland's specific shareable earnings calculations during the hearings. In fact, Roseville agreed with and accepted over one-third of Overland's audit calculations. If ORA's representations of Roseville's shareable earnings are "unproven assertions and claims" as Roseville says they are, Roseville would have challenged them in the NRF hearings.

ORA criticizes Roseville's assertion that Roseville's earned rate of return for 1999 is only 10.53%. This figure is not correct, contends ORA, because it is based on Roseville's unsupported "pro forma" adjustments that it incorporated into the calculation for regulated results of operations. Roseville's pro forma results are based on a misallocation of revenues and expenses between regulated and non-regulated operations and is nothing more than an attempt by Roseville to eliminate the earnings Roseville owes to its ratepayers under the NRF sharing rules.

In its Reply Brief, ORA states it does not dispute that its forecast relies on RCC revenues. However, this is because RTC's revenues for year 2000 are not yet available as we are still in the calendar year. Furthermore, ORA asserts that even though its forecast relies on RCC's revenues, a significant portion of RCC's revenues are derived from RTC, not from other non-regulated operations. Since RTC's revenues constituted approximately 83% of RCC revenues in 1999 according to RCC's annual report, it is entirely reasonable to project RTC's regulated revenues based on a proportion of total RCC revenues.

ORA states Roseville erroneously asserts that ORA's analysis did not consider the trends regarding competitive entry and its impacts on Roseville's regulated revenues. ORA supports the Commission's NRF goals and the fostering of competition in the telecommunications market. Because ORA supports those goals, ORA believes Roseville should not be allowed to receive any permanent subsidy. By seeking a recovery of $11.5 million in subsidy through an external funding source, Roseville is essentially asking the Commission to deter competition from ever flourishing in its service territory. This is so because other potential competitors in Roseville's service territory are not receiving the type of permanent subsidy that Roseville is seeking in this proceeding. As long as Roseville receives a financial subsidy that its competitors are not, there will be no level playing field for competitors.

ORA rebuts Roseville's statement that the Commission should not give any weight to Peters' testimony because he is not familiar with Roseville's actual costs and that the Commission should find Roseville's costs to be reasonable. ORA states the Commission should reject Roseville's arguments about the reasonableness of its costs, since Roseville acknowledged during the hearings that it has not performed any actual cost study since 1991. (1 R.T. 54-55, Gierczak for Roseville.) Neither the Commission nor ORA knows what Roseville's actual costs are. Until Roseville can demonstrate what its actual costs are, the Commission should dismiss Roseville's allegations about the reasonableness of its costs. Peters' estimate of Roseville's costs, based on a comparison to costs incurred by a like-sized, similarly situated company, is not only appropriate, it is the only defensible existing information of Roseville's costs available to the Commission.

According to ORA, Roseville's attempt to undermine Peters' testimony only highlights the unreasonableness of Roseville's costs and demonstrates how inefficient its operations are. Roseville asserts that its operations costs should be compared to the other mid-sized incumbent LEC in California, Citizens. Even though Citizens is not receiving $11.5 million in the form of a subsidy as Roseville is, Citizens' costs are still comparable to Roseville's. ORA wonders how Roseville, which is receiving an $11.5 million subsidy, has costs that are still equivalent to a company that is not receiving such a subsidy.

6.3. Pacific's Position

Peters states in his testimony, "I question whether Roseville requires any replacement funding for the loss of the $11.5 million EAS payments. There is growing evidence that by reasonably increasing its efficiency Roseville can reduce its costs by at least an amount sufficient to offset the loss of the $11.5 million in EAS payments from Pacific." (Exh. 10 at p. 14.)

In his testimony, Peters describes how the Federal Communications Commission (FCC) began disallowing more than one-third of Roseville's Corporate Operations expenses, beginning in 1998, in their determination of the amount of federal support funding for which Roseville was eligible. This expense was disallowed due to the fact that Roseville's Corporate Operations expenses were over 50% higher than the FCC's guideline amounts, which the FCC considered reasonable. This year, Roseville's federal support amounts have been reduced by approximately $2.6 million due to this disallowance. (Id. at 16.)

Peters goes on to say that in 1999 the FCC developed a high-cost support model (as described in FCC 99-036) to estimate the costs that an efficient carrier would incur to provide universal service to various service areas. This model shows that Roseville's booked costs were severely in excess of those which would be incurred by an efficient carrier. Peters concludes that this chain of evidence strongly supports the contention that Roseville has the ability to absorb the discontinuance of Pacific's $11.5 million EAS payments by reasonably increasing the efficiency of its current operations. (Id. at 16-17.)

Peters also stated that the FCC determined that its new high-cost support mechanism would provide sufficient additional funding for non-rural carriers, including Roseville, to maintain affordable rates. The new high-cost support mechanism is based on a model which determines the costs that should be incurred to provide universal service, assuming that service is provided in an efficient manner. The new FCC model showed that an efficiently managed Roseville could maintain affordable rates with no additional funding from outside support sources. Accordingly, states Peters, the FCC is reviewing a proposal to discontinue the universal service support funding currently provided to Roseville from federal sources. (Id. at 18.)

6.4. Discussion

In Roseville's GRC decision in 1996, we found that the EAS payment from Pacific made up a significant portion of Roseville's revenue requirement to provide utility service. Roseville is correct that a regulated utility is entitled to earn a reasonable rate of return. Simply eliminating the $11.5 million from Roseville's revenue stream without any reanalysis of Roseville's revenue requirement would not be reasonable at this time.

ORA and Pacific are opposed to the Commission's granting any replacement revenues for Roseville. ORA cites recent data for RCC regarding operating revenues and net income and concludes that, because of the substantial growth shown in the data, Roseville does not need replacement revenues. ORA describes Roseville as a "financially healthy company."

Similarly, Pacific makes the argument that Roseville should be able to make up the revenues through "efficiencies" based on studies which Pacific prepared using two different sets of FCC data. We find the comparison data which Pacific's witness Peters compiled on Roseville's corporate operations expenses and plant expenses as indicators that there could be problems with Roseville's expenses, but Pacific has provided no specific tie between that data and the specific revenue requirement for $11.5 million. Without quantifiable analysis of specific expense levels, we cannot determine which expenses are unreasonable, and should be used to offset the $11.5 million.

We conclude that we must either order some sort of revenue recovery, or conduct a further analysis of Roseville's revenue requirement, to determine whether the $11.5 million is still a necessary component of Roseville's revenue requirement. We do not have an adequate record before us at this time to support ORA and Pacific's contentions that Roseville does not need any sort of revenue recovery.