Who's taking whom: some comments and evidence on the constitutionality of TELRIC.

• Author: Gabel, David
• Position: Total element long run incremental cost pricing

1. INTRODUCTION

   Valuing the rate base has always been a contentious part of utility regulation. Over the last one hundred years, the Supreme Court has endorsed both original cost and fair-market valuation. At other times, the Court has chosen not to review the valuation method as long as the resulting overall financial performance of the company was reasonable.

   The latest valuation controversy stems from the introduction of competition into the telecommunications arena via the Telecommunications Act of 1996 (1996 Act).(1) Competition has required the unbundling and wholesale pricing of network elements. Wholesale pricing, in turn, requires valuing network elements. Determining this value has created significant controversy. On the one hand, incumbent local exchange carriers (ILECs)(2) argue that in order to provide adequate return on invested capital, elements should be valued at original cost. The Federal Communications Commission (FCC), however, in an effort to promote competition, urges valuing network elements based on forward-looking costs.(3) No doubt the Supreme Court will provide considerable guidance toward the eventual outcome of this issue.

   This Article discusses rate-base valuation, total element long run incremental cost (TELRIC) pricing, and the Court's opinion generally on the issue of takings. Part II begins by examining the pricing rules devised by the FCC under the 1996 Act to promote competition and the ILECs' objections to those rules. The FCC argues that forward-looking TELRIC prices are economically efficient and promote competition.(4) The ILECs contend that if prices are set at a level equal to TELRIC plus a reasonable share of joint and common costs, these prices will:

   [D]eny them recoupment through unbundled network revenues of all historic and/or embedded costs and profit, contrary to the reasonable investment expectations of their investors. To ensure that a taking does not occur, the ILECs argue that the pricing methodology must guarantee the recovery of all prudently incurred costs of investing in local network.(5) To help resolve these conflicting viewpoints, this Article then turns to the Supreme Court's response to the takings question posed earlier in the twentieth century. Part III of this Article discusses the development of the "Fair Value" doctrine and its eventual abandonment in Federal Power Commission v. Hope Natural Gas Co.(6) In Hope, the Court made it clear that it was not willing to review the rate-base valuation process as long as the end result--the financial viability of the company--was adequate.(7) Following similar reasoning, adoption of TELRIC-based pricing may be acceptable as long as companies maintain their financial integrity. The issue of TELRIC and financial viability is examined more deeply in the rest of this Article.

   Part IV looks more carefully at TELRIC pricing and some of the concerns the Supreme Court has already expressed about its adoption. Part IV argues that TELRIC may be no more hypothetical than other pricing standards and that the Regional Bell Operating Companies (RBOCs) and large ILECs have been advocating TELRIC-like pricing for some time. Part IV also makes the point that TELRIC may be no more subjective than other pricing standards such as Ramsey pricing or efficient compound pricing rule (ECPR). Furthermore, both methods require a regulatory commission to estimate the forward looking economic cost of production.

   Part V focuses on whether TERLIC pricing does indeed lead to a taking according to the standard espoused by the Hope Court. While there has been a lot of discussion of this issue in law journals,(8) the question of whether or not a taking has occurred is largely an empirical issue. This Article presents data on the rate of return on the regulated earnings of selected local exchange companies since the passage of the 1996 Act. The companies selected are arguably firms that ought to have experienced the greatest harm from TELRIC-based prices for unbundled network elements. They deaverage costs by density zone yet engage in value of service pricing. The data indicate that the majority of these companies are experiencing more than adequate rates-of-return on regulated capital, a condition that contradicts the ILECs' argument that TELRIC-based prices are confiscatory. Furthermore, recent evidence on the sale of exchanges indicate that the market price for ILEC exchanges is greater than their book value, a clear sign that investors are being adequately compensated for their initial investment.

2. THE TELECOMMUNICATIONS ACT OF 1996

   On February 8, 1996, the 1996 Act was signed into law. The 1996 Act is a comprehensive overhaul of the Communications Act of 1934, making significant changes in the law affecting the regulation of broadcasting, cable, and telephony with less extensive changes in satellite and spectrum regulation and in the FCC's own internal processes.(9)

   Broadly speaking, the intent and purpose of the 1996 Act was "to provide for a procompetitive, deregulatory national policy framework designed to rapidly accelerate private sector deployment of advanced telecommunications and information technologies and services to all Americans by opening all telecommunications markets to competition"(10) thereby securing "lower prices and higher quality services for American telecommunications consumers...."(11)

   One of the principle goals of the 1996 Act regarding the provision of telephone service was to open the local exchange and exchange access markets to competitive entry.(12) In advancing this goal the interconnection section of the 1996 Act, section 251 imposes several obligations on the ILECs. Three important obligations include the following: First, ILECs have a duty to enable competitors to interconnect with the ILECs network, for the transmission and routing of exchange service and exchange access, at any technically feasible point within the network.(13) These services must be offered at rates, terms, and conditions that are just, reasonable, and nondiscriminatory.(14) Second, ILECs must provide unbundled network elements (UNEs) to competitors at any technically feasible point within the network. UNEs must be provided in a manner enabling them to be combined to provide telecommunications service and at rates, terms, and conditions that are just, reasonable, and nondiscriminatory.(15) Finally, ILECs must offer all their retail services for resale by competitors at wholesale rates.(16)

   The FCC has devised pricing rules to implement the provisions of the Act. These rules are among the more contentious issues surrounding the FCC's rulemaking procedures for the full implementation of the Act. In particular, as noted in the introduction, it is the FCC's adoption of the TELRIC Plus methodology for the pricing of unbundled elements and interconnection that has given rise to multiple constitutional challenges by the ILECs and their supporters.

   According to the FCC, its TELRIC Plus methodology is a forward-looking pricing methodology that replicates how competitive markets actually operate and best approximates what it would actually cost an efficient, competitive firm to produce UNEs.(17) The TELRIC Plus pricing of UNEs, as set forth by the FCC, will, according to the FCC and its supporters, adequately compensate the ILECs for all forward-looking costs of providing UNEs, including the costs of capital and provides for a reasonable allocation of joint and common costs.(18) Proponents of TELRIC aver that, because prices are driven to forward-looking costs in competitive markets, "the TELRIC Plus methodology is intended and expected to provide ILECs with a constitutionally sufficient approximation of the fair market value of their property in a competitive market."(19)

   One of the principle ILEC objections to the TELRIC method is that, because it is a forward-looking costing methodology, it fails to permit the recovery of "historical" and "embedded" costs, or, in the language of the regulatory battles of an earlier era, fails to permit the recovery of an ILEC's "prudent investment" in its physical plant and infrastructure and so constitutes a taking of ILEC property.(20)

   The "fair value"(21) methodology and the "prudent investment"(22) methodology (the latter sometimes referred to as "historical" or "embedded"(23) cost methodology) have been variously praised and damned by ratemakers, ratepayers, and the regulated industries over the years.(24) These groups, wavering in their preferences as political and economic expediency dictated, have from time to time shifted in their support for any particular methodology.(25)

   The Supreme Court, in trying to make sense of these shifts, and the resultant slings and arrows of constitutional takings challenges and counterchallenges hurled during the various ratemaking conflicts of the twentieth century, has observed that "neither law nor economics has yet devised generally accepted standards for the evaluation of ratemaking orders"(26) and has, in recent years, sensibly refused to elevate any particular methodology to the level of constitutional mandate, choosing instead to focus its efforts on the overall effects of regulation.

   The U.S. Supreme Court, however, has been drawn into the TELRIC controversy. On January 25, 1999, the Court issued its decision in AT&T Corp. v. Iowa Utilities Board.(27) The Supreme Court held that the FCC had jurisdiction to establish pricing methodologies for state commissions to apply in arbitrations under sections 251 and 252 of the 1996 Act. Due to the jurisdictional nature of the appeal, however, the Court did not address the merits of the FCC's TELRIC methodology for pricing UNEs or its avoided cost methodology for services subject to resale.(28)

   Challenges to the merits of the FCC pricing rules are currently pending before the Eighth Circuit. "Meanwhile, at least thirty-five states have independently approved a TELRIC unbundled elements pricing...