5. Use of CHCF-A for Replacement Funding

5.1. History of CHCF-A

The CHCF-A was originally adopted by the Commission in Decision (D.) 85-06-115 as a means of subsidizing reasonable basic exchange rates for the customers of smaller LECs that concurred in Pacific's statewide average toll, toll private line, and access rates. The Small LECs typically have higher costs than Pacific so rates set at Pacific's levels are insufficient to generate the Small LECs' revenue requirement, including a reasonable rate of return for provisioning these services (i.e. toll, access, toll private line). The rationale provided for the introduction of the CHCF-A was to provide customers of smaller independent LECs with the systemwide rate averaging benefits afforded to Pacific's rural customers by virtue of Pacific having the same rates systemwide within its serving areas.

The CHCF-A rules currently in effect require the Small LECs to comply with a means test and waterfall provision if they request funding from the CHCF-A. The means test ensures that draws from the fund do not result in intrastate rates of return in excess of those authorized by the Commission. The waterfall provision provides the Small LECs with the incentive to file a GRC while funding levels are still high. Appendix A to D.91-09-042 describes the waterfall as follows:

The issuance of a Commission decision in a general rate proceeding of an independent company will have the effect of a "fresh start" for that company under the HCF [High Cost Fund] plan. Specifically, the phase-down of funding shall be reinitiated effective January 1 following the utility's first subsequent annual October advice letter filing after resolution or decision is rendered in the utility's general rate review proceeding. The phase-down cycle under this reinitiation will be six years: three years at 100% funding level following by three succeeding years at 80%, 50% and 0% respectively, if a local exchange company has not initiated a general rate review proceeding by December 31^st of the previous year."

In addition, draws from the CHCF-A also require that a Small LEC's basic rates shall be increased, the increased rate not to exceed 150% of comparable California urban rates.⁶ The revenue from this required basic rate increase is taken into account in determining the amount to be drawn from the CHCF-A. The 150% ceiling on rates was established by the Commission following the enactment of P U Code Section 739.3(a). The Legislature's goal in enacting Section 739.3(a) was to ensure that the rates of rural telephone customers would be at a reasonable level, compared to the rates of urban customers.

5.2. Small LECs' Position

The Small LECs assert the Commission should authorize replacement funding through the CHCF-A. According to the Small LECs, the CHCF-A is the most sensible mechanism to be used to replace settlements payments from Pacific. The CHCF-A is already in existence with a functioning administration, an established billing base, and a positive balance. Using it to provide replacement funding for the Small LECs would be the most expeditious way to proceed.

According to the Small LECs, no party has disagreed with the proposal to utilize the CHCF-A for the proposed purpose. ORA does disagree with the Small LECs' proposal in that ORA recommends retaining the waterfall and means test that today are applied only to the Small LECs' current draws from the fund. It also proposes that the Small LECs be required to raise their basic rate to 150% of Pacific's basic rates, which is a precondition for receipt of existing draws. However, ORA's testimony endorses the general proposition that the CHCF-A is the appropriate funding source to use.

The Small LECs propose that the waterfall and means test procedures that are applied to existing funding not be applied to replacement funding incorporated in the CHCF-A. There are many reasons the Small LECs take this position. First, there are no such mechanisms applied to inter-company settlements revenues today. Instead, when the Commission reviews the rates of the Small LECs, it simply applies those revenues to meeting the Small LECs' overall revenue requirement in order to keep their overall rates reasonable. Inasmuch as the replacement revenues will not grow, there is no compelling reason to change this process at this time.

In addition, the existing waterfall and means test are manageable with respect to existing CHCF-A draws because the amounts they are applied to are relatively small. However, if the replacement revenues are provided via the CHCF-A, the replacement funding will encompass from 30% to 80% of the small companies' intrastate revenues. (Exh. 1, p. 6, Opening Testimony, Bishop for Small LECs). Application of the means test to that large a proportion of a company's revenues essentially means that the company is having a rate case every year. And because the means test is a retrospective review of earnings rather than a forward looking review, it is an inappropriate and unrealistic rate case that will not account for even known changes that will be taking place.

According to the Small LECs, another serious drawback of the means test is the perverse incentive it creates for a Small LEC with respect to investment. If a Small LEC is effectively brought back to its authorized rate of return every year by application of the means test, it has no incentive to pursue efficiencies in its operations. The fruits of these efficiencies are taken away every year. It is a fact of rate-base regulation that a period of time between rate cases where efficiencies realized can be kept by the companies provides the necessary incentive to pursue the efficiencies.

The waterfall is also unreasonable when it is applied to 30% to 80% of a Small LEC's revenues. Suppliers of capital are likely to view the automatic loss of such a large portion of revenue as being too risky, and this may inhibit investment or the availability of loans. Furthermore, rate cases are extremely expensive for Small LECs, and the necessity of filing a rate case to arrest the waterfall could create unreasonable expense that ratepayers would ultimately be required to bear.

Also, both the means test and waterfall are designed to achieve a single objective that can be realized with more appropriate tools. They are designed to ensure that any company's CHCF-A draw does not lead to windfall earnings. However, this is unlikely given the nature of the transition payments and the ability of the Commission to subject the Small LECs to earnings reviews on whatever basis it desires. The payments as proposed are fixed, and, unlike settlements revenues, will not grow as operations expand. This fact will exert a natural pressure on the Small LECs to seek rate relief from the Commission as operations and costs expand, while the transition payment, which makes up a very large portion of small company revenues, remains the same.

Finally, this Commission has the power to order a comprehensive rate review for any or all of the Small LECs at any time to address any perceived earnings issue. This power is flexible, and can be exercised at any time based on an individual company's circumstances. This stands in contrast to a waterfall provision which will require periodic and frequent filings by all Small LECs, regardless of size, resources, and earnings. A pre-scheduled, automatic rate case proceeding is an unnecessary and expensive waste of resources for a company that may be earning at or less than its authorized rate of return.

The Small LECs state that ORA recommends that any CHCF-A draw to replace inter-company settlements payments be reduced for any Small LEC whose rate of return, as calculated by ORA, exceeds the 10% authorized by the Commission in the last round of rate cases. According to the Small LECs, ORA's recommendation is based upon insufficient data. Its calculated rates of return are based upon 1998 recorded data and partial year 1999 recorded data with no ratemaking adjustments. It is not appropriate for the Commission to engage in ratemaking for what now appears to be year 2001 based upon such incomplete, out-of-date, and unadjusted data. As was demonstrated during cross examination of ORA witness Phillips and is evident from Table 1 of Exh. 14, very small swings in small company revenues or expenses can dramatically affect a recorded rate of return. Even relatively small errors or poor data can create an incorrect picture of Small LEC earnings and cause improper reductions in funding.

In their Reply Brief, the Small LECs state that ORA's brief cites data in the record that illustrates the potential for unfair results if the means test is applied for the first time to this major portion of Small LEC revenue streams. ORA notes that Small LEC earnings are erratic and vary widely from year to year. The means test, however, operates to determine the support revenues to be received in a given year based on the recorded results of operations for the first seven months of the preceding year. This is an unsound methodology when earnings fluctuate widely from year to year. The means test is a "one way" adjustment. It is used to reduce revenues when earnings are above a benchmark, but it does not increase revenues or earnings when they are below the benchmark. Over a stretch of time, this bias guarantees that Small LECs will not earn their authorized rates of return. The years when they under-earn will never be offset by comparable years when they over-earn. With the volatility of earnings that ORA points out, the under-earnings years are inevitable.

The illegal nature of such a one-way system was explained in American Tel. & Tel. Co. v. F.C.C., (D.C. Cir. 1988) 836F.2d 1386. In that case the FCC rules at issue limited AT&T's revenues to target rates of return on an annual basis. However it did not adjust revenues upward in the event of a shortfall. The Court of Appeals vacated the rule, stating:

[a] carrier cannot be expected to receive earnings each year at precisely the prescribed rate of return, and from one two year period to the next it must forfeit any excess in earnings while absorbing any deficiency. Thus, over the long run the carrier is virtually guaranteed to fall short of earning its required target rate of return on its combined operations for all such periods viewed together." (Id. at 1390.)

This is precisely the problem with the means test if it is applied to such a large proportion of Small LEC revenues. It will virtually guarantee that the Small LECs do not earn their cost of capital over the long run. Such a situation can be expected to damage them economically and jeopardize service in rural areas.

It is better that Small LEC earnings be evaluated by reviewing information across more than one year, which the Commission can do under the existing ratemaking and reporting structure. This allows for rate cases to be required by the Commission when circumstances actually warrant and avoids the waste of money and other resources that would result from requiring rate cases to be filed even when they are not needed.

5.3. Pacific's Position

Pacific states the CHCF-A is an existing and operating fund which will allow the Small LECs to draw revenue replacement quickly. The fund was established for small companies. It is the appropriate source for permanent replacement funding.

According to Pacific, a waterfall or means test for replacement funding is not necessary. Pool revenues were not traditionally subject to reduction through a means or waterfall test. The Small LECs' earnings are subject to the normal rate review process. Since the Commission has the power to set or adjust replacement funding during the regular course of a periodic rate case, a rate case is the most comprehensive and thus best method to determine future permanent funding reductions or increases.

In its Reply Brief, Pacific asserts that no party disagreed with the proposal to use the CHCF-A as the source of replacement funding for the Small LECs. The only disagreement stems from the IXCs' and ORA's opposition to the elimination of a means test and waterfall provision for this portion of the Small LECs' CHCF-A withdrawals. The IXCs' objections are based on their misconception that the Small LECs are seeking guaranteed CHCF-A funding. The ORA's objections are based on a similar misconception that this would "lower the level of Commission scrutiny over their operations." (ORA's Opening Brief at 8.) According to Pacific, both objections are misplaced.

Pacific states the Small LECs are actually proposing a declining source of outside funding as compared to the current pooling process. This occurs due to the fact that the replacement funding amount is being capped at the current level whereas, under the old pooling process, the Small LECs were receiving increased funding amounts. In fact, between 1995 and 1999, the Small LECs' funding through the pooling process increased by 46%, which is an average annual rate of increase of 10%. This cap on funding, in and of itself, is actually acting as an annual 10% waterfall provision versus their previous funding plan and will require the Small LECs to significantly change their operations to cope with the decline in funding. Due to the fact that this funding source represents 30%-80% of the Small LECs' intrastate revenues⁷ and has been growing at an annual rate of 10% per year, this funding source is completely different than the funding requirements previously placed in the CHCF-A and, therefore, should be treated in a different manner. Pacific concludes it is not appropriate to place additional waterfall provisions over and above that which is already inherent in the process, due to the fact that the amount will be capped.

5.4. ORA's Position

ORA asserts the Small LECs would like to use the instant application to lower the level of Commission scrutiny over their operations by eliminating both the means test and the waterfall provision. ORA recommends that the Commission retain both types of Commission oversight. A quick review of Table 1 from ORA's Direct Testimony, (Ex. 14, p. 2-5), reveals that for calendar year 1999, six of the 13 Small LECs were earning above their Commission authorized rate of return (of 10%) for their intrastate operations, however, all of these companies received funds from the pooling agreements. ORA points out that one firm, Happy Valley Telephone Company, earned a 27.1% rate of return for its intrastate operations for 1999. While the earnings of the Small LECs over the past three years have been erratic, and no firm has earned in excess of 10% all three of the years covered by the table, this erratic earnings pattern is strong evidence of the need for continuing Commission scrutiny over Small LEC operations. A firm such as Happy Valley obviously had a diminished need for pooling revenues in 1999 than it did in previous years, however, under the Small LECs' proposal, payments from the CHCF-A would be essentially an entitlement with no Commission oversight.

According to ORA, reducing Commission oversight over payments from the CHCF-A to the Small LECs runs contrary to the long-term goal of the Commission to eliminate or reduce subsidy payments to the Small LECs and to ensure that local telephone services more closely reflect actual costs.

ORA asserts that continued Commission oversight in the form of the means test and the waterfall provision is important tot ensure the Small LECs are not allowed to use the CHCF-A as a source of earnings (for one company) as high as 17.1% above the Commission'' authorized rate of return. It should also be noted that if the Small LECs are allowed to increase their access charges to NECA-Tariff 5 level rates, over time the need for continuing subsidies from the CHCF-A should diminish. Similarly, as the Small LECs increase their basic exchange rates up to 150% of Pacific's rates, the need for continuing CHCF-A subsidies should diminish.

In its Reply Brief, ORA rebuts the Small LECs' contention in their Opening Brief that it is not appropriate for the Commission to engage in ratemaking for what appears to be year 2001 based upon incomplete, out-of-date, and unadjusted data. ORA responds that in mid-2000, 1999 data can hardly be dismissed as being out of date. Earlier accounting data from 1997 forward is clearly relevant to reflect revenue and expense trends. Further, ORA asserts, nothing precluded the Small LECs from updating the annualized 1999 information to account for any inaccurate estimates the use of annualized numbers might have created.

ORA further notes that the Small LECs have relied on the same "incomplete, out of date, and unadjusted data" to support their position that Small LECs' revenues fluctuate from year to year. If this data is relevant to support the Small LECs' position, it is similarly relevant to debunk it. ORA demonstrated in Exh. 14 that, absent Commission scrutiny (via a means test and the waterfall provision), the Small LECs' proposal to use the CHCF-A as the source of replacement revenues for the toll pooling agreements is likely to lead to continued windfalls for some of the Small LECs.

In its Reply Brief, ORA states that despite the Small LECs' contention to the contrary, there is no evidence in the record of this case to equate a means test with a GRC. The Small LECs themselves acknowledge that a rate case is far more burdensome on their limited staffs than an annual means test. The Commission and the Small LECs have been performing the means test for a number of years.

ORA rebuts another argument promoted by the Small LECs that suppliers of capital are likely to view the loss of between 30-80% of the Small LECs' intrastate revenues as being too risky, which may inhibit investment. According to ORA, the argument is flawed in that the Small LECs' position is based on an unsupported assumption: that the loss of revenues is automatic. According to ORA, the reality is quite different.

The loss of revenue posited by the Small LECs is anything but automatic. What the means test and waterfall provision represent are prudent measures that the Commission can take to stabilize Small LEC finances, assure the investment community of the safety of investments in the Small LECs' service territories and to provide a degree of consumer protection to the ratepayers of the Small LECs that the companies are not over-earning, at ratepayers' expense. Speculative opportunities for excess earnings are not what attracts the investment community to a given utility, but rather a stable revenue stream and consistent earnings. Viewed properly, the Small LECs' proposal to eliminate the means test and waterfall provision is simply a poorly disguised attempt to limit Commission oversight at a time when approximately half of the Small LECs are already earning in excess of Commission-authorized levels. The public interest demands continued Commission vigilance in light of this record.

5.5. The IXCs' Position

The IXCs assert the Small LECs' proposal for guaranteed CHCF-A relief is not in the public interest. First, the Commission has a responsibility to ensure just and reasonable rates for ratepayers, in this instance by protecting ratepayers from overearnings and unreasonable expenses on the part of the Small LECs.

Second, Small LEC witness Bishop stated that the Small LECs' "expense levels are all over the place from year to year. They're not very consistent like you would see in a larger LEC." (1 R.T. 39.) According to the IXCs, this statement is not consistent with the Small LECs' request for guaranteed payments from the CHCF-A. Because the Small LECs have failed to provide cost studies in support of their application, the Commission lacks sufficient evidence to determine whether the guaranteed funding levels requested by the Small LECs support a relatively low or relatively high level of expenses. The concern to ratepayers would be that some Small LECs may be requesting funding based on an unusually high level of expenses, and that these LECs will over-earn at ratepayers' expense in years in which they have more typical, and relatively lower, expenses.

According to the IXCs, the Commission's prime objective is to ensure just and reasonable rates for ratepayers, not guaranteed revenue flows for incumbent LECs. A better solution to protect ratepayers, instead of the guaranteed payments that the Small LECs propose, would be to maintain the safeguards and review of the CHCF-A and have the Small LECs petition the Commission when they have a legitimate emergency. The Small LECs admit that they "have the ability to come and petition the Commission for rate increases if they have an emergency so that they can cover unusual expenses." (1 R.T. 58.)

Finally, the IXCs state that while the Small LECs may have received from Pacific in previous years the amounts they are requesting in this application, that is not a sufficient reason for them to receive those amounts in the future. Evidence presented in this proceeding indicates that a number of the Small LECs earned in excess of their authorized rate of return within the period from 1997 to 1999,⁸ and that several Small LECs appear to have had unreasonably high corporate operations expenses when compared to other Small LECs of the same size, during this same time period.⁹ For all the above reasons, the IXCs say the Commission should reject the Small LECs' proposal for guaranteed funding and should instead apply the current safeguards of the CHCF-A to the Small LECs' new draws of replacement funding.

In their Reply Brief, the IXCs rebut several statements the Small LECs made in their Opening Brief. The Small LECs state that it is unlikely that their draws of replacement funding will lead to windfall earnings. ORA has shown, however, that a number of Small LECs did over-earn during the period from 1997 to 1999, and hence, such overearnings are far from "unlikely."

The IXCs assert the Small LECs seek to reargue the Commission's authorized rate of return of 10%, claiming that:

If a Small LEC is effectively brought back to its authorized rate of return every year by application of the means test, it has no incentive to pursue efficiencies in its operations...[A] period of time between rate cases where efficiencies realized can be kept by the companies provides the necessary incentive to pursue the efficiencies. (Small LEC Brief, p. 9.)

According to the IXCs, in this statement the Small LECs falsely imply that the means test completely prevents them from earning above the Commission's authorized rate of return. Neither the waterfall nor the means test, however, takes away overearnings from completed rate years. Thus, these earnings are, in fact, kept by the Small LECs.

While it may be true that periods between earnings reviews provide LECs with incentives to economize, it is also true that ratepayers pay the additional costs during these periods. The Commission must continually balance efficiency with equity in these situations. For Small LECs, the Commission has already ruled on the proper balance between these two forces, adopting the waterfall and means tests as appropriate regulatory mechanisms for the years between rate cases. Applicants present no new evidence or argument to justify the Commission altering its previous decisions.

The Small LECs also imply that they should be allowed to overearn because "very small swings in small company revenues or expense can dramatically affect a recorded rate of return." (Small LECs Opening Brief at 10.) The Small LECs cite a hypothetical change of $18,000 for Pinnacles Telephone Company, which is by far the smallest LEC. (Id. at 10.) According to the IXCs, this one example, however, only shows that there is much diversity among the Small LECs and does not justify weakening the safeguards of the CHCF-A to benefit all Small LECs. If a particular Small LEC has unusual expenses, it bears the burden to petition the Commission for relief.

In their Reply Brief, the IXCs assert that, although the Small LECs attempt to argue otherwise, the means test actually encourages efficiencies in operations by providing an incentive for the Small LECs to hold down unnecessary costs so that they can achieve the full authorized rate of return of 10%. Similarly, by inducing them to return to the Commission for regular rate reviews, the waterfall provides the Small LECs with an incentive to manage their costs efficiently on a continuing basis.

5.6. Discussion

We find that the CHCF-A is the appropriate source of revenue recovery for the inter-company settlement payments currently made by Pacific. However, the Small LECs and Pacific have not provided compelling reasons why the Small LECs should not be subject to the means test, waterfall, and rate increase requirements associated with draws from the CHCF-A. We created the rules governing the CHCF-A over the past few decades of experience with the fund, and have developed a workable system to maintain reasonable basic exchange rates for customers of small rural telephone companies to further our goal of universal service in rural areas. However, the requirements of the waterfall and means test, and the rate increase requirement, assure us that the companies that draw from the fund are submitting themselves periodically to Commission scrutiny of their operations and are not over-earning. In other words, all California ratepayers should not be funding inefficiencies and excessive earnings by the Small LECs.

While the Small LECs appear to find this a punitive process, we see it as our obligation to protect ratepayer interests, since all ratepayers are subject to the CHCF-A surcharge. The applicants are correct that the current settlement payments from Pacific are not subject to a waterfall and means test, but that begs the issue. Once the payments come from the CHCF-A, instead of from Pacific, we have an obligation to ensure that ratepayer interests are preserved.

The Small LECs try to make the annual CHCF-A filing sound as involved as a GRC, but as ORA points out, the annual means test included in the CHCF-A process in no way equates to a full-blown GRC. The Commission and the Small LECs have been performing this calculation for a number of years.

The Small LECs complain that the means test is a "one way" adjustment which is used to reduce revenues when earnings are above a benchmark, but it does not increase revenues or earning when they are below a benchmark. We disagree. The Small LECs ignore two important facts: 1) If a Small LEC is found to be over-earning in a particular year, no adjustment is made to earnings for that base year. The Small LEC is allowed to keep those over earnings. The Small LEC's revenues are adjusted for the following year to eliminate the over-earning. Therefore, there is no penalty associated with the over earnings in a particular year; and 2) The Small LECs always have the option of coming to the Commission by filing a GRC if their earnings slip to a level which could impair their ability to provide telephone service, or if they incur unanticipated expenses.

The Small LECs' claim that investment companies will be discouraged from investing in the small companies if a large percentage of their revenue could be eliminated if the revenue is subject to the CHCF-A rules. We dispute that conclusion and agree with ORA's and the IXCs' assertion that the investment community will applaud the CHCF-A subsidy which virtually guarantees that the Small LECs will earn their authorized rate of return. This guaranteed subsidy will provide stability for the Small LECs, which should encourage investment.

Five of the Small LEC applicants currently do not have their rates set at 150% of Pacific's, as required by the CHCF-A rules. In the Scoping Memo and Ruling of Assigned Commissioner issued in this proceeding, those Small LECs were required to provide a notice to their customers of a potential rate increase.¹⁰

We have determined that the Small LECs' replacement funding for the STAs shall be subject to the same rules that apply to current draws from the CHCF-A, namely, both the means test and the waterfall provisions will apply. In addition, CHCF-A draws are conditioned on a Small LEC's basic rates being increased up to 150% of Pacific's residential flat rate. Since we are applying the same rules to these draws, we will utilize the same process in place for the current draws.

Small LECs shall be required to make their CHCF-A Advice Letter filings on October 1 of each year, and the Commission will approve those requests by Resolution. This process will commence with the annual filings required October 1, 2001. The Small LECs have already made their October 1, 2000, filings for calendar year 2001, but the Commission has not yet issued a Resolution approving those advice letters. Therefore, the results of this decision will be incorporated into the current process. Within 15 days of the effective date of this Decision, each Small LEC shall supplement its CHCF-A Advice Letter to reflect the results of this Decision.

The Telecommunications Division (TD) is directed to take these supplements into account in processing the Small LECs' 2001 CHCF-A Advice Letter filings. Those Advice Letter filings will be approved by Commission Resolution. Pacific shall be responsible for making its monthly STA payments through the month in which that Resolution is approved, and will have 60 days from the end of that month to complete its payments. The CHCF-A Administrative Committee is directed to begin making the monthly payments to each Small LEC, based on the Commission Resolution approving the Small LECs' Advice Letter filings, beginning the month following the month in which the Resolution is approved. TD will recommend the appropriate surcharge¹¹ rate level for the CHCF-A for calendar year 2001 as part of TD's processing of the Small LECs' Advice Letters. In the Resolution approving the Advice Letters, we will approve or modify TD's recommended surcharge rate level. Within 30 days of the effective date of the Resolution, the CHCF-A surcharge shall be reactivated at a level sufficient to cover the Small LECs' draws. At that time the total amount necessary for 2001 draws from the Fund will be known, which will allow us to reactivate the surcharge at the appropriate level to cover the necessary draws.

Since D.00-09-072 granted the applicants' request to extend the waterfall at the 100% level for one additional year, applicants' 2001 draws will not be subject to the waterfall provision. The issues raised in OP 2 of D.00-09-072 will be addressed in a subsequent decision in this docket.