Discussion of Shared Asset Methodology Proposal

There is merit in Verizon's proposal to use a self-executing process for tracking service affiliate use of Verizon office space and equipment and using this process, with proper safeguards, for what otherwise would be dozens of Section 851 applications. For the kind of routine transactions at issue here, a properly drafted method for streamlining the approval process is welcome both in terms of administrative efficiency and NRF regulation. We agree that such a process benefits ratepayers by timely crediting Verizon for the use of this space and office equipment while at the same time reducing the time and cost required for preparing formal leases and filing Section 851 applications.

The shared asset methodology has been used first by GTE California Incorporated and then by Verizon since 1997. The results on the books of the regulated utility are audited regularly by ORA. Indeed, ORA's most recent audit recommended that a third service affiliate, VDSI, be added to those that use the shared asset methodology or a variation of that methodology.

It is important to note that the shared assets at issue here are office space in buildings owned or leased by Verizon and the office furnishings and equipment that accompany such space, such as cubicles, desks, chairs, desktop computers, file cabinets, and the like. Verizon represents that these are assets that it neither needs nor uses, since the overhead functions they serve have been consolidated in the three service affiliates. By using the assets to provide consolidated administrative-support functions to Verizon, the three service affiliates relieve Verizon from administrative burdens that it would otherwise have to bear on its own.

Affiliate transaction pricing rules require Verizon to charge the three service affiliates the higher of fully allocated cost (FAC) or fair market value (FMV) for their shared use of Verizon's general support assets. Verizon determines this charge by estimating the total number of square feet that the three affiliates occupy in Verizon's buildings, then multiplying that amount by the highest of (1) average FAC for all the shared buildings; (2) the FAC for the building with the majority of the service company employees, or (3) the FMV of the building with the majority of the service company employees (i.e., generally the headquarters building where the highest percentage of shared employees are located).

This pricing calculation - developed in cooperation with ORA during one of its onsite inspections in this docket - results in a conservative approach to compliance with the affiliate pricing rules. ORA states that it agrees with this approach. The sole remaining issue with respect to the methodology itself is how best to estimate the number of square feet allocated to the three service affiliates.

Verizon estimates this square-footage allocation in the aggregate based on a percentage headcount of total employees versus service-affiliate employees co-located in Verizon's buildings. ORA on the other hand would estimate the number of square feet that the service affiliates occupy on a building-by-building basis. The difficulty with ORA's approach is that it assumes that each shared building is fully occupied, when in fact occupancy can range between 50% and 90%. Moreover, it assumes that each building is fully dedicated to administrative functions, when in fact operational use frequently dominates and administrative space may be limited. These assumptions cause ORA's methodology to overstate space usage by the service affiliates.

We conclude that Verizon's methodology provides a more accurate depiction of affiliate usage, and we decline to change the methodology to use ORA's square-footage measure instead of Verizon's headcount measure.

Should the Methodology Take
the Place of 851 Filings?

We turn then to Verizon's request that the shared use methodology take the place of Section 851 filings where the three administrative service affiliates are involved. Verizon maintains that Section 851 does not necessarily require pre-approval of every lease. Instead, according to Verizon, it requires prior approval of any "encumbrance" of utility property. Verizon here seeks Commission approval of a limited category of such "encumbrances" - those where office space and office equipment are used by three service affiliates performing administrative work for several corporate entities, including Verizon.

ORA opposes this approach, arguing that it skirts the requirement of prior Commission approval of each of the service affiliates' leases of Verizon space and equipment.

We begin our analysis by noting that Verizon's licenses for the use of office space and equipment by these affiliates do not require Section 851 approval, and may be performed pursuant to G.O. 69-C under the shared use methodology. Our decision today grants Verizon's request that G.O. 69-C license agreements terminable on 30 days' notice do not require Section 851 approval. To the extent, therefore, that Verizon can fashion its space use agreements with affiliates as licenses terminable on notice of 30 days or less, no Section 851 approval is required. Such license agreements, of course, must meet the three criteria governing G.O. 69-C licenses:

1) The interest granted must not interfere with the utility's operations, practices, and services to its customers.

2) The interest granted must be revocable either upon the order of the Commission or upon the utility's determination that revocation is desirable or necessary to serve its patrons or consumers (i.e., at will); and

3) The interest granted must be for a limited use of utility property.

The use of leases for affiliate use of office space and equipment presents a more difficult issue. As ORA points out, Section 851 specifically requires prior approval of leases. The shared use methodology addresses proper accounting of such lease arrangements, but it does not provide for prior approval of the leases. Without some provision for prior Commission approval of such lease agreements, a utility using only the shared asset methodology to account for these transactions would be at risk of violating Section 851.

In reviewing applications for approval of leases under Section 851, the Commission applies well-established standards to determine the following issues:

· Ensure that the transaction will not impair a utility's ability to provide service to the public;

· Ascertain whether the transaction is accounted for properly, including insuring that revenue is accounted for correctly, and that the utility's rate base, depreciation and other accounts correctly reflect the transaction; and

· Where the transaction is with an affiliate, determine whether the transaction has any anticompetitive effects or results in cross-subsidization of the non-regulated enterprise. (See, e.g., Re Pacific Bell (1996) 68 CPUC2d 123, 125.)

ORA does not challenge the assertion that the shared asset methodology is intended to consolidate common overhead support functions on a regional or national basis to improve operating efficiencies and cut costs. The Commission has determined that transactions such as these will not impair an incumbent competitive local carrier's ability to serve the public. (See, e.g., Re Pacific Bell (1997) 77 CPUC2d 421, approving Pacific Bell's space lease arrangements with affiliates performing administrative support functions.)

Similarly, the accuracy of accounting for this type of space usage is accommodated by the shared asset methodology in tracking the number of service employees and their locations on a monthly basis. The shared asset methodology is linked to Verizon's financial reporting system and is intended to capture all operating expenses associated with Verizon's assets and employees and systematically charges affiliate companies their pro-rata share of expenses, plus a return on investment. The method adjusts on an annual basis to accommodate changes in headcount and costs associated with the space occupied. The shared assets remain part of Verizon's rate base and are reflected in its depreciation accounts.

Similarly, when a transaction is with an affiliate, as here, the Commission in its Section 851 review seeks assurance that there are no anti-competitive effects or cross-subsidization of non-regulated enterprises. We have held that where the administrative services are exclusively in-house, there is no opportunity for anti-competitive effect as the result of collocation, or customer confusion, with respect to the affiliates. (Re Pacific Bell, 68 CPUC2d at 126.) Similarly, we have held that when the assets are basically office furnishings and equipment such as computers and desks, the assets are not the kind that would confer unique advantages on the utility's affiliates, as would intellectual property or telecommunications facilities. (Re Pacific Bell, 69 CPUC2d 206, 210.)

The final element of Commission review under Section 851 concerns the potential for cross-subsidization of affiliate operations through the provision of services from the utility to the affiliate at below-cost prices. In ruling on an earlier Section 851 request by Verizon's predecessor, the Commission concluded that under the utility's California Cost Allocation Manual, the provision of non-tariffed goods and services to other non-regulated affiliates must be priced at the higher of FAC (including ROI) or fair market value. Thus, the cross-subsidization concern is not at issue here.

In sum, we find that the use of the shared asset methodology to deal with encumbrances of Verizon's office space and office equipment by three administrative service organizations (Service Corp, CSI and VDSI) meets the requirements of Section 851 - except for the requirement of prior approval.

ORA acknowledges the administrative appeal of avoiding individual 851 applications for as many as 30 leases to cover the relatively routine use of space and office equipment by Service Corp/CSI/VDSI employees located on Verizon property.

ORA suggests a unique form of Section 851 approval. Since leases of Verizon space and office equipment by Service Corp/CSI/VDSI are all similar, ORA suggests that Verizon be permitted the option of filing an 851 application every three years (or filing the 851 information for approval as part of the triennial NRF review) that would forecast upcoming leases of space and property by Service Corp/CSI/VDSI. If Verizon elects this option for its affiliate leases, it would also be required to file an advice letter annually to update actual use of the lease arrangements that have been approved in advance by the Commission under this procedure. Verizon already does an annual update as part of its shared asset methodology.

ORA also proposes various financial penalties if under this option Verizon fails to accurately forecast the actual leased usage of space by these three affiliates. Absent a showing of ratepayer harm in an inaccurate forecast of leased space, we do not at this time adopt the penalty recommendations in ORA's proposal. Verizon's shared asset methodology charges the service affiliates based on their actual usage determined by current-year headcounts. At the beginning of each fiscal year, Verizon estimates the charges to the affiliates based on the previous year's headcount. Prior to the end of the fiscal year, another headcount is taken to update the shared asset study so that actual charges are recorded in Verizon's books in the year that they occur. This procedure, properly audited, ensures that ratepayers will receive the benefit of this use of utility assets.

We conclude that ORA's recommendation for an 851 filing every three years for the type of leases at issue here complies with the law, serves the public interest, and enhances administrative efficiency. In summary, our order today charts the following course for Verizon in licensing or leasing utility space and office equipment to Service Corp, CSI and VDSI:

(1) Verizon may grant licenses (revocable on notice of 30 days or less) for use of space and office equipment to Service Corp, CSI and VDSI, provided the licenses comply with G.O. 69-C requirements. No prior approval of these arrangements is required under Section 851. The shared asset methodology would continue to be used to account for the use of licensed assets.

(2) Verizon may file a Section 851 application every three years for advance approval by the Commission of all forecasted leases (and licenses that do not comply with G.O. 69-C) of space and office equipment to Service Corp, CSI and VDSI. Alternatively, Verizon may file the 851 information for approval as part of its triennial NRF review. If Verizon elects this option for its affiliate leases, Verizon will be required to file an advice letter annually to update actual use of the lease arrangements that have been approved in advance by the Commission under this procedure. The shared asset methodology would continue to be used to account for the use of leased assets.

(3) Verizon may continue to file individual Section 851 applications for approval of each lease, particularly if the use of G.O. 69-C licenses limits the number of required leases for these affiliates. The shared asset methodology would continue to be used to account for the use of leased assets.

Our order today also requires that the shared asset methodology be included in all future audits of Verizon conducted by ORA or by the Commission. We also adopt ORA's recommendation that the Section 851 procedure that we grant today is limited to the shared space and equipment usages of the three named service entities. Verizon must file a separate application if it seeks similar authority for other activities or other organizations within the corporate structure.

Further Investigation

The second question posed to the parties at the Prehearing Conference on June 14, 2003, was whether further investigation is warranted as to Verizon's transfer of certain business units without prior approval under Section 851. ORA believes further investigation is needed into the transfer of various business units, including product marketing, finance, human resources, legal and public affairs, to Verizon's central service organizations. Verizon opposes further investigation, stating that the transfers were reviewed during ORA's 1999 NRF audit and, in any event, involve the transfer of employees only, not physical assets. ORA states that it intends to address the matter in an upcoming Section 314.5 NRF audit and does not recommend that the issue be addressed in this proceeding. In view of that, we do not reach the issue and will deal with it if and when it comes before us in another proceeding.