In the Matter of Implementation of the Local Competition
               Provisions in the Telecommunications Act of 1996;
              Interconnection between Local Exchange Carriers and
                   Commercial Mobile Radio Service Providers

                   CC Docket No. 96-98; CC Docket No. 95-185

                       FEDERAL COMMUNICATIONS COMMISSION

                              1996 FCC LEXIS 4312

                           RELEASE-NUMBER: FCC 96-325

                August 8, 1996 Released; Adopted August 1, 1996

             ACTION:   [*1]   FIRST REPORT AND ORDER [PART 3 OF 5]

JUDGES:
   By the Commission: Chairman Hundt and Commissioners Quello, Ness, and Chong
issuing separate statements.

OPINION:
   632. Section 252(d)(1) requires, inter alia, that rates for interconnection
and unbundled network elements be based on "cost (determined without reference
to a rate-of-return or other rate-based proceeding)." n1517 We tentatively
concluded in the NPRM that this language precludes states from setting rates by
use of traditional cost-of service regulation, with its detailed examination of
historical carrier investment and expenses. n1518 Instead, we indicated our
belief that the statute contemplates the use of other forms of cost-based price
regulation, such as the setting of prices based on forward-looking economic cost
methodologies (such as LRIC) that do not involve the use of an embedded rate
base. We sought comment on whether section 252(d)(1) forecloses consideration of
historical or embedded costs or merely prohibits state commissions from
conducting a traditional rate-of-return proceeding to establish prices for
interconnection and unbundled network elements. Embedded costs are the costs
that the incumbent LECs carry on their accounting  [*2]   books that reflect
historical purchase prices, regulatory depreciation rates, system
configurations, and operating procedures. We invited parties to comment on
whether incumbent LECs should be permitted to recover some portion of their
historical or embedded costs over TSLRIC. n1519

   n1517 47 U.S.C. @ 252(d)(1)(B).

   n1518 NPRM at para. 123.

   n1519 Id. at para. 129.


   633. In the NPRM, we noted that certain incumbent LECs had advocated that
interconnection and access to unbundled element prices be based on the
"efficient component pricing rule" (ECPR). n1520 Under this approach, an
incumbent LEC that sells an essential input element, such as interconnection, to
a competing network would set the price of that input element equal to "the
input's direct per-unit incremental costs plus the opportunity cost to the input
supplier of the sale of a unit of input." n1521 We tentatively concluded in the
NPRM that ECPR or equivalent methodologies are inconsistent with the section
252(d)(1) requirement that rates be based on "cost," and we proposed to preclude
the states from using this methodology. n1522

   n1520 Id. at para. 147. See William J. Baumol, Some Subtle Issues in Railroad
Deregulation, 10 Int'l J. Trans. Econ. 341 (1983); William Baumol & Gregory
Sidak, Toward Competition in Local Telephony (1994); William Baumol & Gregory
Sidak, The Pricing of Inputs Sold to Competitors, 11 Yale J. on Reg. 171 (1994).
[*3]

   n1521 William Baumol & Gregory Sidak, The Price of Inputs Sold to
Competitors, 11 Yale J. on Reg. 171, 178.

   n1522 NPRM at para. 148.

   634. Section 254 requires the Commission and the Joint Board established
thereunder to ensure that "all providers of telecommunications service . . .
make an equitable and nondiscriminatory contribution to the preservation and
advancement of universal service . . . ." That section further provides that
"there should be specific, predictable, and sufficient Federal and State
mechanisms to preserve and advance universal service." n1523 The Conference
Committee also explained that these provisions require any such universal
service support payment to be, to the extent possible, "explicit, rather than
implicit as many support mechanisms are today." n1524 In the NPRM, we sought
comment on whether "it would be consistent with sections 251 (d)(1) and 254 for
states to include any universal service costs or subsidies in the rates they set
for interconnection, collocation, and unbundled network elements." n1525 In
particular, we discussed the "play or pay" system adopted by the state of New
York in which interconnectors that agree to serve all customers  [*4]   in their
self-defined service areas ("players") potentially pay a substantially lower
interconnection rate than those that serve only selected customers ("payers")
and are, therefore, liable to pay additional contribution charges. n1526 We
noted that the statutory schedule for the completion of the universal service
reform proceeding (15 months from the enactment of the 1996 Act) is different
from that for this proceeding (6 months from the date of enactment of the 1996
Act). We asked whether the ability of states to take universal service support
into account differs pending completion of the section 254 Joint Board
proceeding or state universal service proceedings, pursuant to section 254(f),
during any transition period that may be established in the section 254
proceeding or thereafter. n1527

   n1523 47 U.S.C. @ 254(b)(4) and (b)(5).

   n1524 Joint Explanatory Statement at 130-31. "In keeping with the conferees'
intent that universal service support should be clearly identified, [section
254(e)] shares that such support should be made explicit." Id. at 131; see also
47 U.S.C. @ 254(e).

   n1525 NPRM at para. 145.

   n1526 Id.

   n1527 Id.


   (2) Comments
   635. Forward-Looking  [*5]   Costs. Most new entrants and IXCs agree that
prices for interconnection and unbundled elements should be based on
forward-looking, economic costs. n1528 Many state commissions also argue that,
if federal pricing rules are adopted, forward-looking methodologies should serve
as the basis for establishing rates in a competitive environment. n1529 The
Department of Justice contends that pricing above forward-looking economic costs
would subject competitors to substantial risk of a price squeeze because the
real cost of a network element for the incumbent LEC will be its forward-looking
economic cost, while the cost to the new entrant will be the higher price
charged for the element by the LEC. n1530 Parties favoring a forward-looking,
incremental cost methodology argue that it is the appropriate pricing standard
for several reasons. First, such an approach simulates the prices for network
elements that would result if there were a competitive market for the provision
of such elements to other carriers. n1531 In such a market, these parties argue,
competition would drive prices to forward-looking costs, even if such costs were
lower than a firm's historical costs. n1532 Second, unbundled  [*6]   element
prices based on forward-looking economic costs prevent incumbent LECs from
exploiting their market power at the expense of their competitors that are
dependent on the incumbent LEC's facilities. n1533 Third, a forward-looking
incremental cost methodology creates the right investment incentives for.
competitive facilities-based entry and creates incentives for the market to move
towards competition while preserving opportunities for competition even if some
network elements prove to be resistant to competition. n1534 Fourth, a pricing
methodology based on forward-looking economic costs minimizes the incumbent
LECs' opportunities to engage in anticompetitive cross-subsidization that could
delay the emergence of effective competition. n1535 Finally, these parties argue
that pricing based on forward-looking economic costs will lead to lower prices
for consumers. n1536

   n1528 See, e.g., ACSI comments at 54-55; AT&T comments at 47; Jones
Intercable comments at 25-26; LDDS comments at 60; MCI comments at 59, 61;
NEXTLINK comments at 27; Sprint comments at 43-44; Teleport comments at 46;
Telecommunications Resellers Ass'n comments 38-39; see also Ad Hoc
Telecommunications Users Committee comments at 31-34; DoJ comments at 27-32;
Frontier comments at 21-22; Texas Public Utility Counsel comments at 33-34;
Attorneys General reply at 3; NCTA reply at 18-20; NTIA reply at 17-18 n.35.
[*7]

   n1529 See, e.g., New York Commission comments at 3-4; Missouri Commission
comments at 11; Kentucky Commission comments at 4-5; Wyoming Commission comments
at 27-28; Ohio Commission comments at 41-43.

   n1530 DoJ comments at 28-31.

   n1531 See, e.g., DoJ comments at 28-29.

   n1532 See, e.g., AT&T comments at Appendix C (Affidavit of William J. Baumol,
Janusz A. Ordover, and Robert D. Willig), p.5; DoJ comments at 28-29.

   n1533 See, e.g., DoJ comments at 30.

   n1534 See, e.g., AT&T comments at Appendix C (Affidavit of William J. Baumol,
Janusz A. Ordover, and Robert D. Willig), p.7; DoJ comments at 29; NCTA comments
at Appendix B (Unbundling, Interconnection, and Traffic Exchange: The Pricing of
Access to Local Exchange Networks), p. 22.



   n1535 See, e.g., DoJ comments at 30-31.

   n1536 See, e.g., DoJ comments at 28-31.

   636. While many commenters agree that the proper economic cost standard for
interconnection and unbundled elements is one based on forward-looking LRIC, the
record indicates a lack of consensus on the precise definition of such a
methodology. While many parties, including some incumbent LECs, favor a pricing
methodology based on TSLRIC, n1537  [*8]   others contend that LRIC provides the
appropriate basis for pricing interconnection and unbundled elements. n1538 AT&T
argues that, because incumbent LECs will be providing access to unbundled
network elements and interconnection, and not merely the individual services
that use those elements, the relevant question is the incumbent LEC's cost of
producing the entire demand for network elements. n1539 Because TSLRIC defines a
cost increment relative to a hypothetical situation in which the supplier does
not currently provide the network element at all and thus must construct and
operate all element-specific facilities necessary to produce the network
element, AT&T believes that TSLRIC, unlike LRIC, includes all element-specific
fixed costs. n1540

   n1537 See, e.g., Ad Hoc Telecommunications Users Committee comments at 34-36;
AT&T comments at 47-48; ALTS comments at 35-36; Ameritech comments at 63-64 (but
must include recovery of joint, common, and residual costs); CFA/CU comments at
26-32 (including a contribution to joint and common costs); Citizens Utilities
comments at 18; Comcast comments at 23; CompTel comments at 67-71; Competition
Policy Institute comments at 8; DoJ comments at 28-31 (including any joint and
common costs); Frontier comments at 21-22; Intermedia comments at 14; LDDS
comments at 56, 62; MCI comments at 60-61; NCTA comments at 49-50; Ohio
Consumers' Counsel comments at 24-25 (including a markup over TSLRIC to reflect
a reasonable allocation of joint and common costs); SNET reply at 5-7 (including
a reasonable contribution to common costs); Sprint comments at 44 (plus a
reasonable contribution to joint and common costs), reply at 28-32; TCC comments
at 14.  [*9]

   n1538 See, e.g., Texas Statewide Tel. Cooperative comments at 8-11, 14.

   n1539 AT&T comments at 47, Appendix C (Affidavit of William I. Baumol, Janusz
A. Ordover, and Robert D. Willig), pp.6.

   n1540 Id. at 48.


   637. The Consumer Federation of America argues that costs must be analyzed
consistently across all major services using the same cost methodology, i.e.,
individual functionalities or specific capacities must have similar costs across
services. n1541 AT&T argues that TSLRIC should exclude all costs attributable to
the incumbent LECs' retailing operations, and that all other cost allocations
should be competitively-neutral and assigned on an equally proportional basis
relative to attributable costs. n1542 ALTS argues that the underlying data from
a TSLRIC study should be accessible for purposes of replicating the study
methods and comparisons to other public data. n1543 NTIA contends that the
Commission should require the states to consider recovery of only those costs
that the incumbent can convincingly demonstrate are incurred in service
provisioning. n1544 Supporters of a forward-looking economic cost methodology
argue that TSLRIC studies can be prepared quickly  [*10]   to establish
interconnection and unbundled element prices. n1545
   n1541 CFA/CU comments at 32.

   n1542 AT&T comments at 61-62, 64-65.

   n1543 ALTS comments at 36-37.

   n1544 NTIA reply at 28.

   n1545 See, e.g., LDDS comments at 64-65.

   638. Incumbent LECs generally oppose the adoption of a forward-looking,
long-run incremental costing methodology. n1546 At least five major reasons are
offered in opposition. First, opponents of a forward-looking, long-run
incremental costing methodology argue that setting the price of each discrete
service based on LRIC will not recover the total costs of the network because if
prices are set equal to the cost of the last unit, total revenues will fall
short of total costs. n1547 Second, PacTel argues that a forward-looking cost
methodology also suffers from the "fallacy of perfect competition" because it
does not account for the fact that, while it is true that competition drives the
price of every product toward incremental cost, every multi-product firm must
have some products priced far enough above incremental cost to recover its total
costs and return a profit to investors. n1548 Third, incumbent LECs argue that
setting prices   [*11]   based on the forward-looking economic cost of the
element will not create incentives for new entrants to build their own
facilities, n1549 and will discourage efficient entry and useful investment by
both incumbent LECs and their competitors. n1550 Fourth, some opponents of a
forward-looking, economic cost methodology contend that such an approach raises
significant practical and administrative problems because LRIC studies are
expensive to conduct, almost impossible to audit or review particularly for
small entities seeking to enter the local exchange market, highly subjective,
and the necessary data are under the exclusive control of the party subject to
the agreement. n1551 USTA and other commenters also argue that use of LRIC cost
studies would fail to capture differences in geographic regions, thereby denying
small incumbent LECs a reasonable opportunity to recover their costs. n1552
Finally, many opponents of a forward-looking, economic cost approach to pricing
interconnection and access to unbundled elements argue also that such a
methodology precludes any contribution to joint and common costs and does not
allow the recovery of historical costs. n1553 These parties contend   [*12]
that network providers must be permitted to recover their total costs of
service, including a return on investment and a reasonable allocation of joint,
common, and historical costs. n1554

   n1546 See, e.g., Matanuska comments at 3-4; NYNEX comments at 46-47; PacTel
comments at 66-67; TCA comments at 8.

   n1547 See, e.g., Bell Atlantic comments at Attachment 1 (Affidavit of Jerry
A. Hausman), pp.34; NECA comments at 8; Rural Tel. Coalition comments at 25.

   n1548 PacTel comments at 68-69; see also Rural Tel. Coalition reply at 26-27.

   n1549 See, e.g., Bell Atlantic comments at 38; SBC comments at 91-92.

   n1550 See, e.g., PacTel comments at 70; SBC comments at 90-92; see also U S
West comments at Exhibit A (Federal Implementation of the Telecommunications Act
of 1996: Competition in the Local Exchange), p.9.



   n1551 See, e.g., Bell Atlantic comments at Attachment 2 (Declaration of
Robert W. Crandall), p.8; MFS comments at 54, reply at 11-12; NECA comments at
8.

   n1552 E.g., USTA comments at 45-50; Bay Springs reply at 8.

   n1553 See, e.g., BellSouth comments at 56-57; NYNEX comments at 50-52; PacTel
comments at 65-66; SBC comments at 88, reply at 24-25; U S West reply at 9, 12
(stating that depreciation expenses should be properly allocated); see also NECA
comments at 8; TCA comments at 8-9. For a discussion of recovery of joint,
common, and embedded costs, see infra Section VII.B.2.a.  [*13]

   n1554 See, e.g., Ameritech comments at 60, reply at 30-33 (stating that
residual cost recovery must also be permitted); Bell Atlantic comments at 35-36
(stating that the recovery of the total costs of constructing and operating the
networks must also be permitted); NYNEX comments at 42-44; USTA comments at
Attachment 1 (Affidavit of Jerry A. Hausman), pp.5-6.

   639. Incumbent LECs generally contend that costs should be based on the
individual incumbent LEC's existing network design and technology instead of the
idealized least-cost, most efficient network design and technology. n1555 USTA
argues that, if competitors want to use an incumbent LEC's embedded plant,
competitors should pay for the existing plant, not some theoretical, more
efficient plant. n1556 In addition, these parties argue that, if a new entrant
can purchase the unbundled element from the incumbent LEC at a price no higher
than the cost of the least-cost, most efficient provider, then the new entrant
has little incentive to invest in its own facilities. Ameritech also contends
that section 252(d)(1) addresses recovery of the incumbent LEC's costs of
providing interconnection and unbundled network elements, not  [*14]   the costs
of a hypothetical carrier. n1557

   n1555 See, e.g., Ameritech reply at 32-33; Bell Atlantic reply at 17-18;
Bellsouth reply at 36-37; see also GVNW comments at 36; USTA comments at 40,
reply at 21-22.

   n1556 USTA comments at 40.

   n1557 Ameritech reply at 32.

   640. On the other hand, several new entrants argue that a forward-looking
economic cost methodology should be based on an efficient provider's costs of
producing a service. n1558 These parties contend that, in a competitive market,
prices are determined by the cost of efficient potential entrants, not the
embedded costs of existing firms. n1559 In addition, a pricing standard based on
the costs of the element using the most-efficient technology prevents incumbent
LECs from charging competitors for the cost of facilities that would in fact be
used in large part by the incumbent LECs themselves to compete in new markets
such as interexchange service. n1560 Sprint, however, argues that prices should
be based on the incumbent LEC's average utilization and existing network design
and technology, not on an idealized network and technology that may bear no
relationship to the incumbent LECs existing operations. n1561  [*15]


   n1558 See, e.g., ACSI comments at 56; AT&T comments at 57-60 (optimally
configured and sized assets with current technology and efficient operating
practices); AT&T comments at Appendix C (Affidavit of William J. Baumol,
Janusz A. Ordover, and Robert D. Willig), p. 10 (efficient, cost-minimizing
competitor); GST comments at 26-27 (costs of an efficient LEC rather than the
actual costs of an incumbent LEC); Teleport reply at 30 (best available
technology at today's prices); see also DoJ reply at 9-11 (best generally
available technology); Louisiana Commission comments at 4, 15;
Telecommunications Resellers Ass'n comments at 38 (most efficient available
technology).

   n1559 See, e.g., TCC comments at 17.

   n1560 DoJ reply at 10.

   n1561 Sprint reply at 31-32.

   641. USTA, Bell Atlantic, and BellSouth have asserted in various filings and
ex parte presentations that TSLRIC-based pricing would not properly compensate
incumbent LECs for certain factors that affect capital costs and economic
depreciation rates. n1562 First, when technological progress lowers equipment
costs, the replacement or forward-looking economic cost of certain durable sunk
investments can be expected to  [*16]   decline over time. In this case the
correct measure of cost over any period of time should include the expected
decline in economic value during that period. n1563

   n1562 USTA reply comments at Attachment 1 (Reply Affidavit of Jerry A.
Hausman); Bell Atlantic comments at Attachment 1 (Affidavit of Jerry A.
Hausman); Letter from Robert T. Blau, Vice President, Executive and Federal
Regulatory Affairs, BellSouth, to William F. Caton, Acting Secretary, FCC, July
25, 1996, at Attachment (Response to Hubbard and Lehr).

   n1563 We note that USTA seems to present a contradictory argument regarding
the expected effect of this issue -- here Hansman claims that prices will
decrease rapidly, whereas in our price cap proceeding, USTA sponsored testimony
by Christenson that claimed input prices would generally increase at the rate of
inflation. USTA comments in CC Docket No. 94-1, at 25-27.


   642. Second, these parties argue that, when investments in facilities needed
to meet a specific level of demand are sunk and irreversible, an incumbent LEC
may not be able to recover these costs over the physical life of the facility,
because demand may decrease as new entrants elect to build their own  [*17]
facilities. When entry is possible using current technology, either competition
from these entrants, or rate regulation can prevent retail service prices from
rising significantly, which will place an effective ceiling on profits. If
demand for a service falls in a market in which the incumbent LEC is the only
supplier and owner of sunk facilities, however, there will be no corresponding
exit of other carriers that will prevent prices and profits from falling.
Because of this asymmetric effect of changing market conditions on an incumbent
LEC's profits, these parties claim that increasing the uncertainty due to entry
in the local exchange market will increase the cost of capital to the incumbent
LEC. They then assert that the inability of TSLRIC to account for the risks
associated with sunk facilities can lead to understating the true economic cost
of an element by a factor of three. n1564 Finally they assert that empirical
research that shows firms' hurdle rates in excess of the market cost of capital
shows that the considerations of risk associated with sunk investment
significantly raises a firm's cost of capital. n1565
   n1564 See USTA reply at Attachment 1 (Reply Affidavit of Jerry A. Hausman),
p. 1.  [*18]

   n1565 Id. at 7.

   643. Joint and Common Costs. Several incumbent LECs contend that a
forward-looking, economic cost methodology does not take into account either
joint or common costs. n1566 Although a few parties contend that incumbent LECs
do not need a mark-up over TSLRIC to recover joint and common costs because
incumbents are presumably already recovering these costs, n1567 commenters
generally agree that incumbent LECs should be permitted to recover some measure
of forward-looking joint and common costs. n1568 These commenters argue that
pricing at incremental cost without joint and common costs is economically
inefficient because it permits competitors to offer the incumbent LECs' services
without making a contribution to the common costs that the LECs incur in
offering the service. n1569 They further contend that excluding recovery of
joint and common costs will distort technological decisions because the LEC is
encouraged to invest in less efficient technologies that have higher incremental
costs and lower common costs, which would tend to destroy economies of scope.
n1570 Finally, incumbent LECs fear that they will be forced to increase retail
rates to recover these   [*19]   unrecovered common costs, while their
competitors that do not face such costs will reduce their own prices and have
little incentive to invest in facilities of their own. n1571

   n1566 See, e.g., Bell Atlantic comments at Tab 2 (Declaration of Robert W.
Crandall), p.9, reply at Attachment 1 (Declaration of Alfred E. Kahn and Timothy
J. Tardill), p.6; BellSouth comments at 51; Municipal Utilities comments at
19-21; SBC reply at 24-25; TDS comments at 18-19.

   n1567 See Telecommunications Resellers Ass'n comments at 39-40; Texas Public
Utility Counsel comments at 19-20; WinStar comments at 29, reply at 9-10.

   n1568 See, e.g., Ameritech comments at 60; Bell Atlantic comments at 36;
Citizens Utilities comments at 19; Cincinnati Bell comments at 24-25; Colorado
Commission comments 45-46; DoJ reply at 6; GTE Comments at 61-62; Kentucky
Commission comments at 5; Lincoln Tel. comments at 13; Mass. Commission comments
at 11-12; NCTA comments at 49-50; Ohio Consumers' Counsel comments at 24; SBC
comments at 91; Sprint comments at 4344; AT&T reply at 28; NTIA reply at 19-21;
USTA reply at 19.

   n1569 E.g., BellSouth comments at 52-53; GTE comments at Attachment 3
(Affidavit of Edward C. Beauvais, Ph.D.), p.3.  [*20]

   n1570 See, e.g., BellSouth comments at 53; Lincoln Tel. comments at 13.

   n1571 E.g., BellSouth comments at 53-54.


   644. There is no consensus in the record on the magnitude of the joint and
common costs at stake. Although commenters argued that the mount of common costs
varies dramatically due to differences in location, network construction, and
equipment, n1572 several parties are skeptical that there are significant joint
and common costs between network elements given the relative modularity of the
network and associated functions. n1573 These parties contend that, if joint and
common costs are incurred, incumbent LECs must quantify them so that a state
commission can determine whether and precisely how much contribution is
needed. n1574 The Department of Justice asserts that, when developing a TSLRIC
for unbundled network elements, it is preferable, where possible, to focus on
costs of facilities and network elements rather than services that use those
facilities in order to arrive at a more accurate determination of economic costs
and to reduce the amount of costs that must be treated as joint or common. n1575
The incumbent LECs disagree with the new entrants' characterization  [*21]   of
these costs as de minimis and argue that there is no evidence that unrecovered
joint and common costs are much lower in the TSLRIC rates for physical elements
than a TSLRIC standard based on the cost of providing services. n1576

   n1572 See, e.g., Municipal Utilities comments at 19-20; NARUC reply at 9.

   n1573 See, e.g., AT&T comments at Attachment or Appendix C (Affidavit of
William J. Baumol, Janusz A. Ordover, and Robert D. Willig), pp.13-14;
Competition Policy Institute comments at 19; DJ comments at 31-32, reply at 8;
Texas Public Utility Counsel comments at 24-25.

   n1574 Texas Public Utility Counsel comments at 17-28; Sprint comments at
47-50.

   n1575 DoJ reply at 8; see also Competition Policy Institute comments at 19.

   n1576 E.g., PacTel reply at 27; see also Cincinnati Bell reply at 10.

   645. There is considerable disagreement in the record over the appropriate
method of allocating joint and common costs under a TSLRIC approach. AT&T
contends that the vast majority of the relevant costs will be causally
attributed to particular network elements in the calculation of TSLRIC, and that
we should prescribe rigid allocators that limit the incumbents' ability  [*22]
to manipulate prices by imposing high markups on new entrants. n1577 This
approach, it is argued, is more competitively neutral than Ramsey pricing, which
allocates costs based on inverse demand elasticity. n1578 In contrast, incumbent
LECs advocate allocation of joint and common costs based on inverse demand
elasticity, n1579 i.e., according to Ramsey pricing principles. n1580 New
entrants and other parties oppose the use of Ramsey pricing for interconnection
and unbundled network elements for use in a market that is moving toward
competition over the long-run. n1581 They contend that Ramsey pricing enables
LECs to shift costs associated with entry into new competitive markets over to
captive services. n1582 One state commission responds that the Commission's
concern in this regard would be addressed by calculating demand elasticities on
the basis of the total industry demand for the service, which would negate the
influence of competition on demand elasticities. n1583

   n1577 See AT&T comments at 61-62.

   n1578 See, e.g., Teleport comments at 47-48.

   n1579 See e.g., GTE comments at 63, comments at Attachment 3 (Affidavit of
Edward C. Beauvais, Ph.D.), pp.4-6; see also Mass. Commission comments at 11-12.
[*23]


   n1580 See Frank P. Ramsey, A Contribution to the Theory of Taxation, 37 Econ.
J. 47 (1927); see generally Kenneth E. Train, Optimal Regulation: The Economic
Theory of Natural Monopoly 115-40 (1992) (discussing efficiency properties of
Ramsey prices); Bridger M. Mitchell & Ingo Vogelsang, Telecommunications
Pricing: Theory and Practice 43-61 (1991).

   n1581 See, e.g., Ad Hoc Telecommunications Users Committee comments at 39-41;
CompTel comments at 79-80; MECA comments at 45; Teleport comments at 47-48;
Texas Public Utility Counsel comments at 27; WinStar reply at 10-11.

   n1582 See, e.g., Ad Hoc Telecommunications Users Committee comments at 38-39.

   n1583 See, e.g., Mass. Commission comments at 12.

   646. Commenters suggested other means of allocating joint and common costs.
For example, certain incumbent LECs argue that these costs must not be shifted
from interconnection and unbundled elements to residential subscribers, n1584
while certain new entrants suggest that these costs should be recovered at the
retail level. n1585 Many new entrants agree that the Commission should require
allocation of joint and common costs that minimizes the opportunity for
incumbent LECs  [*24]   to harm competitors through strategic pricing. n1586 For
example, some new entrants argue that states should be required to minimize
allocation of joint and common costs to bottleneck or essential network
elements. n1587 MCI and Sprint assert that such costs should be spread across
all services provided by a carrier in proportion to the TSLRIC for each service.
n1588 A few commenters assert that the Commission should adopt a fixed mark-up
over TSLRIC for allocation of joint and common costs. n1589 Cable & Wireless
supports the adoption of a rule that allocates common costs uniformly for all
services offered. It argues that a disproportionate allocation system, that for
example, assigns common costs strictly to retail services purchased for resale
by small companies, but not to unbundled network elements utilized by larger
competitors, would prove detrimental to the development of local competition.
n1590 Finally, certain parties suggested that regardless of the method
ultimately used to allocate joint and common costs, TSLRIC should serve as the
floor n1591 and prices should not exceed stand-alone costs. n1592

   n1584 See, e.g., Puerto Rico Tel. comments at 10; Rural Tel. Coalition
comments at 27.  [*25]

   n1585 E.g., MCI reply at 9-10.

   n1586 See, e.g., MCI reply at 9-10.

   n1587 See, e.g., LCI comments at 4-5 (even under a TSLRIC methodology, it may
be necessary to allocate joint direct costs among classes of service); Time
Warner comments at 52-53 (only elements that can be duplicated by competitors or
that are already available from other sources should include a reasonable markup
over TSLRIC for shared and common costs); see also CFA/CU comments at 33-35
(allocation to such elements should be no more than the allocation of such costs
to basic service).

   n1588 See AT&T comments at 64; MCI reply at 9-10; Sprint comments at 47.

   n1589 See, e.g., Competition Policy Institute comments at 19 (suggesting an
overhead loading of six percent); see also Sprint comments at 48-49 (joint and
common costs should be no more than 15 percent of TSLRIC).

   n1590 Cable & Wireless comments at 35.



   n1591 See, e.g., Citizens Utilities comments at 19; Florida Commission
comments at 26; SBC comments at 93-94.

   n1592 See, e.g., AT&T comments at Appendix C (Affidavit of William J. Baumol,
Janusz A. Ordover, and Robert D. Willig), pp. 14-15; TDS comments at 21.

   647. Reasonable  [*26]   Profit. Commenters disagree over what should
constitute a "reasonable profit." Numerous commenters argue that a TSLRIC-based
methodology for the pricing of interconnection and unbundled network elements
includes a reasonable profit and is, therefore, consistent with the 1996 Act.
n1593 These commenters argue that economic measures, such as TSLRIC, reflect a
reasonable profit by including the cost of capital. n1594 Time Warner and
NEXTLINK contend that permitting incumbent LECs to receive a profit above that
contained within TSLRIC pricing would provide them with a greater return on
facilities than was permitted under rate-of-return regulation by
"double-counting" the profit. n1595 Furthermore, NEXTLINK rejects the notion
that profit includes the recovery of embedded costs or is a means of recovering
subsidies for universal service currently recovered through access charges such
as the transport interconnection charge or carrier common line charge, or their
intrastate equivalents. n1596 Similarly, LDDS believes that "reasonable profit"
cannot be read to include contribution to costs having nothing to do with
providing the network elements or interconnection that are the subject of
[*27]   a section 252 pricing standard. n1597

   n1593 See, e.g., ConapTel comments at 69-70; LDDS comments at 61; MCI
comments at 61-62; Texas Public Utility Counsel comments at 19-20; WinStar
comments at 29; Ad Hoc Telecommunications Users' Committee reply at Appendix A
(Interconnection Pricing Standards for Monopoly Rate Elements in a Potentially
Competitive Local Telecommunications Market), p. 12.

   n1594 E.g., AT&T reply at 31; CompTel comments at 69-70, reply at 39; DoJ
reply at 9; Frontier reply at 12-15; MCI comments at 61-62; Texas Public Utility
Counsel comments at 19-20; WinStar comments at 29.

   n1595 NEXTLINK comments at 28; Time Warner reply at 31-32.

   n1596 NEXTLINK comments at 28-29.

   n1597 LDDS comments at 61.


   648. Incumbent LECs, however, contend that setting rates on a TSLRIC-based
methodology alone would violate section 252(d)(1) by precluding recovery of a
reasonable profit. n1598 NYNEX and USTA state that profit is what a firm makes
after it recovers its total costs of providing all of its services, including
its investment-related costs. n1599 Ameritech similarly contends that the term
"reasonable profit" means the ability to earn positive economic profits  [*28]
as an incentive for efficiency and innovation. n1600 PacTel argues that, in
order to allow for a reasonable profit, rates for interconnection and unbundled
elements must permit full recovery of historical accounting costs. PacTel
charges that the federal courts have held that the determination of a
"reasonable profit" should consider the effect on the carrier's whole enterprise
and, therefore, the sum of the carrier's rates must enable it to recover its
total historical costs. n1601
   n1598 See, e.g., GTE comments at 60; NYNEX comments at 51-52; PacTel comments
at 69; SBC comments at 88; TCA comments at 9; TDS comments at 18; see also GTE
comments at Attachment 3 (Affidavit of Edward C. Beauvais, Ph.D.), p.9.

   n1599 See NYNEX comments at 42; USTA comments at 3.

   n1600 See Ameritech comments at 70-71.

   n1601 See PacTel comments at 65-66, citing FPC v. Hope Natural Gas, 320 U.S.
591 (1944) and Jersey Central Power & Light v. FERC, 810 F.2d 1168, 1172 (D.C.
Cir. 1987).

   649. Several parties contend that the issue of what constitutes a reasonable
profit should be left to the states. Citizens Utilities contends that the issue
of whether profit is reasonable is a question   [*29]   of fact to be resolved,
where necessary, in arbitration proceedings. n1602 Time Warner argues that what
constitutes reasonable profit should, as a matter of policy, vary depending on
the nature of the facilities or services being provided and should, therefore,
be left to the states. n1603 The Illinois Commission argues that states may even
use rate-of-return methodologies for the determination of reasonable profit.
n1604

   n1602 Citizens Utilities comments at 17.

   n1603 Time Warner comments at 52.

   n1604 Illinois Commission reply at 15.

   650. There is also disagreement among the commenters regarding the force of
the reasonable profit language in section 252. While many incumbent LECs
interpret Section 252(d)(1) as requiring prices to include a reasonable profit,
n1605 certain new entrants and other parties argue that the reasonable profit
language is permissive, not mandatory. n1606 For example, several LECs contend
that, to avoid confiscation of their property, LECs are entitled to full
operating expenses as well as the capital costs of doing business and a
reasonable profit. n1607 The Ohio Consumers' Counsel, however, argues that the
language of section 252(d)(1) indicates  [*30]   that it is at the discretion of
the state commissions to determine whether to allow rates to reflect a
reasonable profit. n1608

   n1605 See, e.g., PacTel comments at 65-66.

   n1606 See, e.g., AT&T reply at 31; Cox reply at 29; DoJ reply at 15.

   n1607 See, e.g., MECA comments at 44, 49; PacTel comments at 65-67.

   n1608 Ohio Consumers' Counsel comments at 26.


   651. USTA contends that "purely forward-looking TSLRIC" should not be the
price for interconnection elements because "telecommunications networks are
mostly sunk costs." n1609 It argues that, when investment in facilities requires
sunk and irreversible costs, a firm may not be able to recover this investment
over the physical life of the facilities due to the risks of decreases in value
resulting from future competition. USTA contends that allowing other carriers
into the provision of local exchange service will subject incumbent LECs to
these types of risks. It then claims that TSLRIC calculations do not
appropriately account for these additional risks.

   n1609 See USTA reply at Attachment 1 (Reply Affidavit of Professor Jerry A.
Hamman), p. 1.

   652. USTA also argues that the risks to which the incumbent LECs   [*31]
will be subject as a result of competition in the local exchange market include
the risks from facing new competition, technological change, change in demand,
and interest rates. It farther argues that these risks will result in many
situations in which the incumbent LECs may face a reduction in profits (downside
risk) and no situations in which the incumbent LECs may see an increase in their
profits. Thus, incumbent LECs must be compensated for these additional risks,
according to USTA. It concludes that TSLRIC calculations fail to provide this
compensation, stating "TSLRIC can be biased downward by a factor of three."
n1610

   n1610 Id. at 6. Presumably, by TSLRIC, Professor Hausman is referring to a
TSLRIC assuming a risk free rate of return and a depreciation rate that
encompasses the physical life of assets.

   653. Similarly, Bell Atlantic asserts that, in a market where input prices
are declining, a TSLRIC standard is not the appropriate standard because, "in a
world of continual technological progress, it would be irrational for firms
constantly to update their facilities in order completely to incorporate today's
lowest-cost technology." n1611 Thus, it argues that because a  [*32]   carrier
would not replace its entire existing set of facilities (a sunk investment) with
the best available technology at a given point, the price of the best available
technology understates the cost of providing service. n1612

   n1611 Bell Atlantic reply at Exhibit 1 (Declaration of Alfred E. Kahn and
Timothy J. Tardiff), para.8a.

   n1612 Id.

   654. The Consumer Federation of America, disputing the incumbent LECs' claims
regarding risk premiums, argues that risk premiums are reflected in the large
returns incumbent LECs have already earned. n1613

   n1613 See CFA/CU comments at 61-63.


   655. Embedded Costs. IXCs, competitive local entrants, and others interpret
section 251 (d)(1) as precluding states from setting rates by use of traditional
cost-of-service regulation, with its detailed examination of historical
accounting costs and reliance on an embedded rate base. n1614 These parties
argue that some measure of forward-looking economic costs, not historical costs,
should be the only basis for setting rates for interconnection and unbundled
network elements because only forward-looking economic costs meet the statutory
requirement in section 252(d)(1) that such rates be "determined  [*33]   without
reference to a traditional rate-of-return or other rate-based proceeding."
Potential new entrants and many other commenters argue that historical or
embedded costs should not be included in the prices of interconnection and
unbundled network elements. n1615 NTIA asserts that it is unwise to include in
the prices for interconnection and unbundled elements an amount to recover
historical costs when the size of any shortfall between historical costs and
TSLRIC's forward-looking costs will not be determined for many years after
interLATA entry. n1616 These parties contend that permitting incumbent LECs to
recover embedded costs in the prices they charge competitors for interconnection
and unbundled network elements, while the incumbents experience much lower
incremental costs, will result in inefficiently high prices that will either
cause new entrants to over-build existing systems instead of maximizing the
efficient use of the existing incumbent LEC's network, or discourage entry and
investment in the local markets altogether. n1617 Moreover, opponents of
embedded cost recovery maintain that these costs reflect past inefficiencies and
their recovery does not create any incentive  [*34]   for incumbent LECs to
maximize their network and operational efficiencies. n1618 Commenters also argue
that embedded cost recovery permits incumbents to engage in anticompetitive,
strategic, or discriminatory pricing by manipulating the cost of individual rate
elements. n1619

   n1614 See, e.g., AT&T comments at 47; LDDS comments at 60; MCI comments at
61-62; MFS comments at 59; Sprint comments at 43; Teleport comments at 46; Time
Warner comments at 51; Frontier comments at 21; Excel comments at 9; ACSI
comments at 54-55; WinStar comments at 37-38; GST comments at 29-30; see also Ad
Hoc Telecommunications Users Committee comments at 30-31; DoJ comments at 27-32,
reply at 14; Kentucky Commission comments at 4; Texas Public Utility Counsel
comments at 33-34; Telecommunications Resellers Ass'n comments at 38; Michigan
Commission comments at 14; Pennsylvania Commission comments at 29; Ohio
Commission comments at 42-43; Attorneys General reply at 7-8.

   n1615 See, e.g., AT&T comments at 47; CFAJCU reply at 18-19; DoJ comments at
27-32; N. Economides comments at 3; Frontier comments at 21-22, reply at 13;
Jones Intercable comments at 25-26; LDDS comments at 60; MCI comments at 61-62;
MFS comments at 59; Michigan Commission comments at 14; Sprint comments at 43;
Teleport comments at 46; TCC comments at 15-16; Texas Public Utility Counsel
comments at 33-34; Time Warner comments at 51; WinStar comments at 37-38; see
also Ad Hoe Telecommunications Users' Committee reply at Appendix A
(Interconnection Pricing Standards for Monopoly Rate Elements in a Potentially
Competitive Local Telecommunications Market), pp.2-6;  [*35]

   n1616 See NTIA reply at 28-29.

   n1617 See, e.g., Competition Policy Institute comments at 8; TCC comments at
15-16.

   n1618 See, e.g., Ad Hoc Telecommunications Users Committee comments at 53-54.

   n1619 TCC comments at 15-16


   656. In response to claims that the incumbent LECs are entitled to recover
embedded costs incurred as a result of their regulation, opponents of embedded
cost recovery argue that, at the state level, incumbent LECs have been opting
for incentive-based regulation and so have foregone the right to claim
entitlement to recovery of embedded costs in exchange for the flexibility to
price their services to meet competition. n1620 AT&T argues that, because the
majority of the incumbent LECs' embedded plant was installed after 1990, the
forward-looking replacement costs of this old plant may in many cases be higher
than the incumbent LECs' embedded costs. n1621 MCI disagrees with incumbent
LECs' claims that excluding historical costs will discourage future investment
by incumbent LECs and argues instead that incumbent LECs make investment
decisions based upon expected future earnings. n1622

   n1620 See, e.g., GST comments at 29-30; WinStar comments at 38.  [*36]

   n1621 See AT&T reply at 33. For a detailed discussion, see AT&T reply at
Appendix C (Affidavit of Lee Selwyn and Patricia Kravtin), pp. 14.

   n1622 See MCI reply at 15-16.

   657. Most incumbent LECs and some other parties dispute the claim that
historical costs are precluded by the statute, n1623 asserting instead that
section 252(d)(1) merely prohibits the use of a rate-of-return proceeding to
determine such rates. n1624 Incumbent LECs argue that any pricing methodology
the Commission adopts should permit recovery of historical or embedded costs in
the prices of interconnection and unbundled network elements. n1625 NYNEX
specifically proposes a cost-accounting pricing methodology that places the
burden on the incumbent LEC to identify the specific accounting data that would
be associated with the particular type of interconnection requested by the
competing carrier under section 251. n1626

   n1623 See, e.g., Bell Atlantic comments at 37; BellSouth reply at 35-37;
Colorado Commission comments at 34-35; GVNW comments at 35-36; Municipal
Utilities comments at 19; NYNEX comments at 46-47; Ohio Consumers' Counsel
comments at 23; PacTel comments at 65; Roseville Tel. comments at 6-8; Rural
Tel. Coalition comments at 26-28; SBC comments at 88; TDS comments at 17-18;
Texas Statewide Telephone Coop. Inc. comments at 7; USTA comments at 40.
[*37]

   n1624 See, e.g., Bell Atlantic comments at 37; Municipal Utilities comments
at 19; Ohio Consumers' Counsel comments at 23; Texas Statewide Telephone Coop.
comments at 7.

   n1625 See, e.g., Alaska Tel. Ass'n comments at 4-5; Ameritech comments at 60;
Bell Atlantic comments at 36; Cincinnati Bell comments at 30; Lincoln Tel.
comments at 11-12; Roseville Tel. comments at 7-8; SBC comments at 59; SNET
comments at 29; USTA comments. at 40; see also NECA comments at 6, reply at 8-9.

   n1626 NYNEX comments 54-56, reply at 27.


   658. USTA cites reports that estimate that embedded costs that would not be
recouped under a solely forward-looking pricing methodology are between $ 13
billion and $ 18.4 billion. n1627 Incumbent LECs contend that, because incumbent
LECs must offset this shortfall of revenues against total costs that is created
by a failure to recover embedded costs, they will be discouraged from investing
to maintain and upgrade their networks in order to avoid the risk of again being
unable to recover embedded costs. n1628 In addition, they argue that they
incurred these embedded costs under federal and state regulatory oversight,
which imposed on incumbent LECs social  [*38]   policy obligations and
uneconomic costing practices, and that they therefore should be permitted to
recover them. n1629 Incumbent LECs also assert that past investments were made
under the belief that costs would be recovered, and that rates collected in the
past did not reflect the risk that embedded costs might not be recovered in
future rates. n1630 Several commenters argue that the opportunity to recover
embedded costs through rates for interconnection and unbundled elements is
particularly important for small and rural incumbent LECs. n1631 Finally, some
parties also contend that, if they are not permitted to recover embedded costs,
these costs must be recouped elsewhere, thus putting pressure on the states to
recover these costs through local rates. n1632

   n1627 USTA comments at 55.

   n1628 See, e.g., Bell Atlantic comments at Attachment 1 (Affidavit of
Professor Jerry A. Hausman), p.2; Lincoln Tel. comments at 16-17; USTA reply at
23.

   n1629 See, e.g., Ameritech reply at 30-31; BellSouth comments at 57; Lincoln
Tel. comments at 16-17.

   n1630 See Bell Atlantic reply at Exhibit 2 (Declaration of Richard A.
Epstein), p.4.

   n1631 E.g., Home Tel. comments at 4; NECA comments at 9; TCA comments at 8;
Texas Statewide Tel. Cooperative, Inc. comments at 9; Bay Springs reply at 10.
[*39]

   n1632 See, e.g., USTA comments at 56; Wyoming Commission comments at 31-32;
see also New York Commission reply at 9; cf., Alabama Commission comments at
24-25; Texas Commission comments at 23, 26.

   659. Despite their objections to embedded cost recovery, some non-incumbent
parties explain conditions under which some limited recovery should be
permitted. For example, MCI argues that, although embedded costs should not be
recovered, it would be appropriate to allow incumbent LECs to recover any
depreciation reserve deficiency, n1633 which MCI estimates is only a small
percentage of the residual between existing revenues and the revenues generated
by a forward-looking, TSLRIC pricing of unbundled network elements. n1634 The Ad
Hoc Telecommunications Users Committee asserts that, at a minimum, any nominal
losses in economic value attributed to stranded investment should be weighed
against the appreciation in value that incumbent LECs have experienced as
reflected in share prices and market-to-book ratios. n1635 The Consumer
Federation of America proposes that stranded investment might be recovered
through an industry-wide recovery fund, if incumbent LECs can satisfy a rigorous
set  [*40]   of showings to ensure that ratepayers are fairly treated. n1636
Finally, AT&T argues that, if the Commission determines that some portion of the
residual should be recovered, it should be recovered through a competitively
neutral, transitional, funding and distribution mechanism that will not distort
competition. n1637

   n1633 A reserve imbalance exists when the carrier's actual "book"
depreciation reserve differs from its "theoretical" reserve, which is the
reserve which would exist if service lives and salvage values had been
accurately forecast in the past. When the theoretical reserve exceeds the book
reserve, the imbalance is a reserve deficiency. For most LECs the reserve
imbalance is an overall deficiency. Amortization of Depreciation Reserve
Imbalances of Local Exchange Carriers, CC Docket No. 87447, Report and Order, 3
FCC Rcd 984 (1988).

   n1634 See MCI comments at 73-75.



   n1635 Ad Hoc Telecommunications Users Committee comments at 26-27.

   n1636 See CFA/CU comments at 67-68.

   n1637 See AT&T comments at 70-73.

   660. Opportunity Cost -- ECPR. Incumbent LECs are the primary advocates for
ECPR pricing of interconnection and unbundled network elements. n1638   [*41]
They argue generally that ECPR is the approach that most closely parallels the
method a firm in a competitive market would employ when faced with the
opportunity of selling inputs to firms that intend to compete with it in its
final product market. n1639 GTE asserts that the ECPR's purpose is to reward
efficient entry into the market for the end product by ensuring that the
incumbent LEC sells network access to itself and to its rivals on the same,
nondiscriminatory terms. n1640 Thus, GTE claims, the ECPR sets prices for
network elements that provide incentives for efficient entry and compensates
incumbent LECs for the economic costs associated with sale of such elements.
n1641 GTE further argues that ECPR accomplishes these tasks regardless of the
market structure and regardless of the presence or absence of economic rents.
n1642 SBC argues that the ECPR is equivalent to the avoided cost rule used for
setting the prices of resold services and equivalent to the efficient imputation
role for pricing of retail services. n1643 Supporters of ECPR pricing also argue
that prices will continue to move toward competitive levels where competition is
provided by a more efficient carrier than  [*42]   the incumbent LEC. n1644

   n1638 See, e.g., Ameritech comments at 91-93; GTE reply at 36-38; MECA
comments at 50-52; PacTel comments at 69-71; SBC comments at Appendix A
(Efficient Component Pricing Rule), pp.1-5; see also PacTel reply at Appendix C
(Declaration of Richard D. Emerson).

   n1639 See, e.g., Rural Tel. Coalition reply at 28-30.

   n1640 GTE comments at Attachment 4 (An Empirical Analysis of Pricing Under
Sections 251 and 252 of the Telecommunications Act of 1996), p.7.

   n1641 Id. at p.I-i

   n1642 Id. at p. III-7.

   n1643 SBC comments at Appendix A (Efficient Component Pricing Rule), pp. 1-5.

   n1644 See, e.g., Ameritech comments at 93; GTE comments at Attachment 4 (An
Empirical Analysis of Pricing Under Sections 251 and 252 of the
Telecommunications Act of 1996), p. III-6-8.


   661. New entrants and many other commenters oppose the use of the ECPR to set
prices for interconnection and access to unbundled network elements. n1645 These
parties argue that ECPR does not comply with the statutory mandate that
interconnection and network elements be based on costs. They assert that using
ECPR would allow incumbent LECs to retain monopoly rents and protect   [*43]
the incumbent LECs from competitive disciplinary market forces. n1646 Opponents
of ECPR contend that ECPR pricing does not replicate a competitive environment,
but instead perpetuates inefficient and anticompetitive aspects of the current
pricing structure. Other commenters argue that the incumbent LECs may use ECPR
to exclude or marginalize a more efficient rival in the complementary market
by forcing the rival to operate on the higher end of its cost curve through
higher interconnection charges. They also argue that prices based on ECPR create
incentives for incumbent LECs to shift costs of their competitive services to
their bottleneck services, which distorts competition. n1647 Finally, opponents
of ECPR assert that ECPR pricing shields the largest share of costs possible
from competition, preserves the status quo, and imposes a barrier to entry.
n1648

   n1645 See, e.g., Ad Hoc Telecommunications Users Committee comments at 55;
ALTS reply at 26-29; Cable & Wireless comments 35; California Commission reply
at 20; CFA/CU comments at 41-45; CompTel reply at 40-49; Cox reply at 29; DoJ
reply at 11-13; Frontier comments at 23; Mass. Attorney General comments at 6-9;
MCI comments at 70-71, reply at 16; MFS comments at 60 n.67; Ohio Consumers'
Counsel comments at 25 n.7, reply at 15; Sprint comments at 59 n.33; Texas
Public Utility Counsel comments at 36; Time Warner comments at 56-58;
Telecommunications Resellers Ass'n comments at 41-42; WinStar comments at 41.
[*44]

   n1646 See, e.g., Cable & Wireless comments 35; California Commission reply at
20; CompTel reply at 40; Mass. Attorney General comments at 6-8; Time Warner
comments 56-58; Telecommunications Resellers Ass'n comments at 41-42.

   n1647 See, e.g., N. Economides comments at 4-6.

   n1648 See, e.g., CFA/CU comments at 42.

   662. Baumol, Ordover, and Willig, principal authors-of the theory, explain
that ECPR is not applicable for pricing of interconnection and unbundled network
elements because the existing end user rates for local telecommunications are
not appropriate as a baseline for ECPR. They claim that cross-subsidies are
common in the current rates, and rates depart systematically from pertinent
costs. Baumol, Ordover, and Willig conclude that applying ECPR to existing rates
would result in component prices that lock in the incumbent LECs' monopoly
profits and pricing inefficiencies, and would attract inefficient entry, where
rates are too high, and would preclude efficient entry where rates are too low.
n1649

   n1649 See AT&T comments at Appendix C (Affidavit of William J. Baumol, Janusz
A. Ordover, and Robert D. Willig), pp.g-9.


   663. Universal Service Subsidies. Most  [*45]   parties other than incumbent
LECs and some state commissions agree that it would be inconsistent with both
the cost-based rate requirements of section 252(d)(1) and the requirement in
section 254(b)(5), that universal service support mechanisms "be specific [and]
predictable. . ." n1650 for states to include any universal service subsidies in
the rates they set for interconnection, collocation, and unbundled network
elements. n1651 They argue that the 1996 Act requires that rates reflect the
economic cost of providing network elements and interconnection and does not
authorize subsidies that have nothing to do with economic costs. n1652 With
regard to the requirements of section 254, these parties argue that, to the
extent rates need to be subsidized for universal service purposes, the subsidy
should be collected from all carriers on a non-discriminatory and competitively
neutral basis. n1653 The Washington Commission relates its own experience of
ejecting US West's request for a per minute universal service charge to cover
"carrier of last resort" obligations and its finding that residential rates
were sufficient to cover the costs of residential service. n1654

   n1650 47 U.S.C. @ 254(b)(5).  [*46]

   n1651 See, e.g., ACTA comments at 23; AT&T comments at 70-73; Competition
Policy Institute comments at 20; CompTel comments at 73-74; DoJ comments at
56-59; MCI comments at 75; NEXTLINK comments at 29; Sprint comments at 61-62;
Telecommunications Resellers Ass'n comments at 39 n.76; Teleport comments at
48-49; WinStar comments at 40-41, reply at 13-14.

   n1652 AT&T and CompTel further contend that to permit any universal service
subsidies in the rates set for interconnection, collocation and unbundled
network elements would be to base rates on the embedded costs of incumbent LEC
expenditures rather than the forward-looking economic costs of providing a
network element as mandated by section 252(d)(1). See AT&T comments at 70-73;
CompTel comments at 72-74.

   n1653 See, e.g., ACTA comments at 23; AT&T comments at 69; Massachusetts
Commission comments at 8-10; MCI comments at 75; Michigan Commission comments at
19.

   n1654 Washington Commission reply at 6.

   664. In contrast, several incumbent LECs and state public utility commissions
maintain that incumbent LECs should be permitted to recover their embedded costs
in the rates set for interconnection, collocation, and unbundled  [*47]
network elements. These commenters claim that rates based on incremental costs
alone fail to account for certain costs historically incurred to accomplish
carrier-of-last-resort and universal service social policy objectives. n1655 The
Attorneys General caution the Commission not to classify legitimate
contributions to joint and common costs as impermissible implicit universal
service subsidies. n1656

   n1655 See, e.g., Alabama Commission comments at 24-25; Bay Springs, et al.
comments at 16; BellSouth comments at 57; Matanuska Tel. comments at 2-3; TDS
comments at 20; SBC comments at 89; Western Alliance comments at 6-7; but see
BellSouth comments at 57 (if the universal service proceeding establishes a
federal fund or if the states establish explicit funds, there will be no need
for subsidies to be built into interconnection and unbundled network element
rates).

   n1656 Attorneys General reply at 10-11.


   665. Several parties comment on the issue of how universal service funding
should be handled during the interim period between the effective date of this
order and the effective date of the Commission's order implementing the section
254 universal service requirements in May  [*48]   1997. AT&T proposes that the
Commission adopt a competitively-neutral funding and distribution mechanism.
n1657 CompTel proposes that the Commission grant a blanket waiver of incremental
cost pricing for exchange access. Under CompTel's plan, pending completion of
the section 254 proceeding, the incumbent LECs would continue to provide
exchange access pursuant to their intrastate and interstate carrier-to-carrier
access charge tariffs. At the conclusion of the section 254 proceeding, the
Commission would determine whether the incumbent LECs are entitled to recover
any portion of those revenues from competitive carriers and, if so, devise
appropriate mechanisms for doing so. CompTel asserts that, by preserving the
status quo for exchange access until those issues are fully considered and
resolved, the Commission would ensure that the 1996 Act does not cause any
unnecessary short-term disruption to carriers or consumers. n1658

   n1657 AT&T comments at 73.

   n1658 CompTel comments at 84.

   666. The Western Alliance contends that states should have authority to order
the recovery of lost contribution through access charges until explicit and
competitively neutral support mechanisms  [*49]   are in place. n1659 Similarly,
the Massachusetts Commission argues that the states should have authority to
include universal service subsidies in the rates for interconnection during this
period. The Massachusetts Commission further contends that prohibiting states
from exercising this authority will promote inefficient competition and
ultimately could result in confiscation claims being filed by incumbent LECs.
n1660

   n1659 Western Alliance comments at 6-7.

   n1660 Mass. Commission comments at 9-10.

   667. Some parties take the position that "play or pay" proposals incorporate
implicit subsidies into rates for interconnection and unbundled network elements
and are therefore inconsistent with the 1996 Act. n1661 They further argue that
such programs violate the 1996 Act because they do not require all
telecommunications carriers to contribute on an equitable and nondiscriminatory
basis and do not qualify as "specific, predictable and sufficient mechanisms" to
preserve and advance universal service. n1662

   n1661 See, e.g., Frontier comments at 23; Teleport comments at 4849; Texas
Public Utility Counsel comments at 35-36; WinStar reply at 14 n.20.

   n1662 WinStar comments at 40; see also Texas Public Utility Counsel comments
at 35.  [*50]

   668. Other commenters argue, however, that the 1996 Act permits reasonable
differences in interconnection rates charged to carriers so long as
similarly-situated carriers are treated alike. They maintain that the
anti-discrimination provisions of the 1996 Act only prohibit unreasonable
discrimination. Thus, they contend that "play or pay" schemes are consistent
with the 1996 Act. n1663 Several parties also contend that such schemes are
authorized by the reservation of state power to adopt and implement universal
service measures in section 254. n1664 Moreover, the New York Commission argues
that the section 254(e) requirement that universal service funding must be
explicit applies only to the federal Universal Service Fund, which is yet to be
established, and not to state initiatives. n1665

   n1663 See, e.g., New York Commission comments at 15-18; NYNEX comments at
91-97.

   n1664 NYNEX comments at 95-97; New York Commission reply at 6.



   n1665 New York Commission reply at 6.

   669. Some commenters urge the Commission to address universal service in the
section 254 proceeding rather than in the section 251/252 interconnection
proceeding. n1666 Other commenters suggest that   [*51]   universal service,
access restructure, and interconnection issues should be addressed in a
coordinated manner or in a consolidated proceeding. n1667

   n1666 See, e.g., Competition Policy Institute comments at 13-14; F.
Williamson comments at 8; Texas Public Utility Counsel comments at 36; ALTS
reply at 35.

   n1667 See, e.g., Ad Hoc Telecommunications Users Committee comments at 35;
TDS comments at 20.

   670. Fifth Amendment Issues. Several incumbent LECs claim that use of a
LRIC-based pricing methodology that does not permit recovery of at least joint
and common costs and a reasonable profit constitutes unlawful confiscation in
violation of the Fifth and Fourteenth Amendments. n1668 Other LECs further argue
that, in order to avoid an unconstitutional taking, any pricing rules we adopt
must enable them to recover total costs, including historical or embedded costs.
n1669 Generally, these parties contend that prices limited by a forward-looking
economic cost methodology do not permit an incumbent LEC to remain profitable
over time because LRIC fails to recover total costs. n1670 They assert that, if
the Commission decides now, long after those costs have been sunk, to bar
compensatory  [*52]   returns, it will violate due process and undermine the
incumbent LECs' legitimate, investment-backed expectations. n1671 Such
interference with legitimate investor expectations, they contend, constitutes an
unlawful taking. n1672 GTE contends that Commission adoption of a pure TSLRIC
methodology would represent an unconstitutional taking, because it would require
use of the incumbent LEC's physical property, thus giving rise to an obligation
to provide just compensation. n1673

   n1668 See, e.g., GTE comments at 65-71; MECA comments at 42; Puerto Rico
Telephone Company reply at 11-12; PacTel comments at 67.

   n1669 See, e.g., NYNEX comments at 43-44; PacTel comments at 65-66; SNET
comments at 29; Roseville Tel. comments at 6-7.

   n1670 See, e.g., Ameritech comments at 62-70; GTE comments at 68-71, reply at
31-32; USTA comments at 39-42.

   n1671 See, e.g., GTE comments at 66-71, reply at 31-33; USTA comments at
40-45, reply at 21-25, 32-34.

   n1672 Id.

   n1673 See GTE comments at 65-67.


   671. Other parties, including the Department of Justice and new entrants,
contend that using a forward-looking cost-based pricing methodology for setting
the rates for interconnection  [*53]   and unbundled elements does not
constitute an unlawful taking. n1674 These commenters point out that many state
commissions already utilize a forward-looking cost-based pricing methodology.
n1675 They also argue that, because forward-looking cost-based rates capture
all costs for interconnection and unbundled network elements, including the
risk-adjusted cost of capital, such a methodology would not result in an
unlawful taking. n1676 These parties further assert that the LECs' takings
claims are premature, not demonstrated with sufficient specificity, and
overstate the scope of the constitutional guarantee. n1677 Commenters note that
no incumbent LEC has made any effort to demonstrate the actual impact of a
LRIC-based pricing methodology on its "financial integrity." n1678 These parties
contend that there is no unconstitutional impairment if the shortfall is not
sufficient to jeopardize the operating and financial integrity of the utility.
Finally, these commenters maintain that there is no constitutional right to a
particular rate-setting methodology (i.e., historical cost) and there are no
general principles that require every component of an integral whole of a
utility service  [*54]   to show a profit. n1679

   n1674 See, e.g., ALTS reply at 8-11; AT&T comments at 70-71; CompTel reply at
37-40; DoJ reply at 13, 16-19; MCI reply at 18-20.

   n1675 See, e.g., AT&T comments at 49-50; Cable & Wireless reply at 24-25; MCI
reply at 19. AT&T also notes that when U S West and BellSouth have been new
entrants into markets, they have advocated a LRIC approach. AT&T comments at
50-51 n.72.

   n1676 See, e.g., Frontier reply at 14; MCI reply at 18-19.

   n1677 See, e.g., DoJ reply at 16-18.

   n1678 DoJ reply at 16-18; MCI reply at 18.

   n1679 See, e.g., Jones Intercable reply at 16-17.

   (3) Discussion

   672. Overview. Having concluded in Section II.D., above, that we have the
requisite legal authority and that we should establish national pricing rules,
we conclude here that prices for interconnection and unbundled elements pursuant
to sections 251 (c)(2), 251 (c)(3), and 252(d)(1), should be set at
forward-looking long-run economic cost. In practice, this will mean that prices
are based on the TSLRIC of the network element, which we will call Total Element
Long Run Incremental Cost (TELRIC), and will include a reasonable allocation of
forward-looking joint and  [*55]   common costs. The 1996 Act encourages
competition by removing barriers to entry and providing an opportunity for
potential new entrants to purchase unbundled incumbent LEC network elements to
compete efficiently to provide local exchange services. We believe that the
prices that potential entrants pay for these elements should reflect
forward-looking economic costs in order to encourage efficient levels of
investment and entry.


   673. In this section, we describe this forward-looking, cost-based pricing
standard in detail. First, we define the terms we are using, explain how the
methodology we are adopting differs from other costing approaches, and describe
how it should be implemented. In particular, we explain that the price of a
network element should include the forward-looking costs that can be attributed
directly to the provision of services using that element, which includes a
reasonable return on investment (i.e., "profit"), plus a reasonable share of the
forward-looking joint and common costs. Second, "we address potential cost
measures that must not be included in a TELRIC analysis, such as embedded (or
historical) costs, opportunity costs, or universal service subsidies.   [*56]
Finally, we refute arguments that this methodology would violate the incumbent
LECs' rights under the Fifth Amendment.

   (a) Total Element Long Run Incremental Cost

   674. Definitions of Terms. In light of the various possible definitions of a
number of the critical economic terms used in this context, we begin by defining
terms as we use them in this Order. Specifically, we provide. definitions for
the following terms: "incremental cost;" "economic cost;" "embedded or
accounting cost;" "joint cost;" "common cost;" "long run incremental cost;"
"total service long run incremental cost;" "total element long run incremental
cost." In addition to defining these terms, we explain the economic rationale
behind the concepts.

   675. Incremental costs are the additional" costs (usually expressed as a cost
per unit) that a firm will incur as a result of expanding the output of a good
or service by producing an additional quantity of the good or service. n1680
Incremental costs are forward-looking in the sense that these costs are incurred
as the output level changes by a given increment. n1681 The costs that are
considered incremental will vary greatly depending on the size of the increment.
For  [*57]   example, the incremental cost of carrying an additional call from a
residence that is already connected to the network to its end office is
virtually zero. The incremental cost of connecting a new residence to its end
office, however, is the cost of the loop. Forward-looking incremental costs,
plus a portion of the forward-looking joint and common costs, are sometimes
referred to as "economic costs." Embedded or accounting costs are costs that
firms incurred in the past for providing a good or service and are recorded as
past operating expenses and depreciation. Due to changes in input prices and
technologies, incremental costs may differ from embedded costs of that same
increment. In competitive markets, the price of a good or service will tend
towards its long-run incremental cost.

   n1680 See 1 Alfred Kahn The Economics of Regulation 66 (1971); William Baumol
and Gregory Sidak, Toward Competition in Local Telephony 57 (1994).

   n1681 William Baurnol and Gregory Sidak, Toward Competition in Local
Telephony 57 (1994).

   676. Certain types of costs arise from the production of multiple products or
services. We use the term "joint costs" to refer to costs incurred when two or
[*58]   more outputs are produced in fixed proportion by the same production
process (i.e., when one product is produced, a second product is generated by
the same production process at no additional cost). The term "common costs"
refers to costs that are incurred in connection with the production of multiple
products or services, and remains unchanged as the relative proportion of those
products or services varies (e.g., the salaries of corporate managers). Such
costs may be common to all services provided by the firm or common to only a
subset of those services or elements. If a cost is common with respect to a
subset of services or elements, for example, a firm avoids that cost only by not
providing each and every service or element in the subset. For the purpose of
our discussion, we refer to joint and common costs as simply common costs unless
the distinction is relevant in a particular context.



   677. The term "long run," in the context of "long run incremental cost,"
refers to a period long enough so that all of a firm's costs become variable or
avoidable. n1682 The term "total service," in the context of TSLRIC, indicates
that the relevant increment is the entire quantity of the service  [*59]   that
a firm produces, rather than just a marginal increment over and above a given
level of production. Depending on what services are the subject of a study,
TSLRIC may be for a single service or a class of similar services. TSLRIC
includes the incremental costs of dedicated facilities and operations that are
used by only the service in question. TSLRIC also includes the incremental costs
of shared facilities and operations that are used by that service as well as
other services.

   n1682 See, e.g., William Baumol, Economic Theory and Operations Analysis 290
(4th ed. 1977) (The very long run is a period so long that all of the firm's
present contracts will have run out, its present plant and equipment will have
been worn out or rendered obsolete and will therefore need replacement, etc.").

   678. While we are adopting a version of the methodology commonly referred to
as TSLRIC as the basis for pricing interconnection and unbundled elements, we
are coining the term "total element long run incremental cost" (TELRIC) to
describe our version of this methodology. The incumbent LEC offerings to be
priced using this methodology generally will be "network elements," rather than
"telecommunications  [*60]   services," as defined by the 1996 Act. n1683 More
fundamentally, we believe that TELRIC-based pricing of discrete network elements
or facilities, such as local loops and switching, is likely to be much more
economically rational than TSLRIC-based pricing of conventional services, such
as interstate access service and local residential or business exchange service.
As discussed in greater detail below, separate telecommunications services are
typically provided over shared network facilities, the costs of which may be
joint or common with respect to some services. The costs of local loops and
their associated line cards in local switches, for example, are common with
respect to interstate access service and local exchange service, because once
these facilities are installed to provide one service they are able to provide
the other at no additional cost. By contrast, the network elements, as we have
defined them, n1684 largely correspond to distinct network facilities.
Therefore, the amount of joint and common costs that must be allocated among
separate offerings is likely to be much smaller using a TELRIC methodology
rather than a TSLRIC approach that measures the costs of conventional  [*61]
services. Because it is difficult for regulators to determine an
economically-optimal allocation of any such joint and common costs, we believe
that pricing elements, defined as facilities with associated features and
functions, is more reliable from the standpoint of economic efficiency than
pricing services that use shared network facilities.

   n1683 47 U.S.C. @@ 3(29), 3(46).

   n1684 See supra Section V.


   679. Description of TELRIC-Based Pricing Methodology. Adopting a pricing
methodology based on forward-looking, economic costs best replicates, to the
extent possible, the conditions of a competitive market. In addition, a
forward-looking cost methodology reduces the ability of an incumbent LEC to
engage in ant-competitive behavior. Congress recognized in the 1996 Act that
access to the incumbent LECs' bottleneck facilities is critical to making
meaningful competition possible. As a result of the availability to
competitors of the incumbent LEC's unbundled elements at their economic cost,
consumers will be able to reap the benefits of the incumbent LECs' economies of
scale and scope, as well as the benefits of competition. Because a pricing
methodology based on forward-looking  [*62]   costs simulates the conditions in
a competitive marketplace, it allows the requesting carrier to produce
efficiently and to compete effectively, which should drive retail prices to
their competitive levels. We believe that our adoption of a forward-looking
cost-based pricing methodology should facilitate competition on a reasonable and
efficient basis by all firms in the industry by establishing prices for
interconnection and unbundled elements based on costs similar to those incurred
by the incumbents, which may be expected to reduce the regulatory burdens and
economic impact of our decision for many parties, including both small entities
seeking to enter the local exchange markets and small incumbent LECs. n1685

   n1685 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

   680. We note that incumbent LECs have greater access to the cost information
necessary to calculate the incremental cost of the unbundled elements of the
network. Given this asymmetric access to cost data, we find that incumbent LECs
must prove to the state commission the nature and magnitude of any
forward-looking cost that it seeks to recover in the prices of interconnection
and unbundled network elements.   [*63]

   681. Some parties express concern that the information required to compute
prices based on forward-looking costs is inherently so hypothetical as to be of
little or no practical value. n1686 Based on the record before us, we disagree.
A number of states, which ultimately will have to review forward-looking cost
studies in carrying out their duties under section 252, either have already
implemented forward-looking, incremental costing methodologies to set prices for
interconnection and unbundled network elements or support the use of such an
approach. n1687 While these states have applied somewhat different definitions
of, and approaches to setting prices developed on, an incremental cost
methodology, the record demonstrates that such approaches are practical and
implementable.

   n1686 See, e.g., GVNW comments at 35; NYNEX comments at 54; USTA comments at
47-50.

   n1687 See, e.g., Louisiana Commission comments at 4; Texas Commission
comments at 22; Washington Commission comments at 25; California Commission
comments at 28-29; Colorado Commission comments at 35; Maryland Commission
comments at 7-8; Oklahoma Commission comments at Attachment A (Oklahoma
Corporation Commission Telephone Rules, OAC 165:55) pp. 10-11. The Wyoming and
Florida commissions have indicated their support for such an approach. See
Wyoming Commission comments at 27 (supporting uniform use of TSLRIC costing
methods so long as details left to states); see also Florida Commission comments
at 26 (TSLRIC may be appropriate to set cost standard for a price floor).
[*64]


   682. We conclude that, under a TELRIC methodology, incumbent LECs' prices for
interconnection and unbundled network elements shall recover the forward-looking
costs directly attributable to the specified element, as well as a reasonable
allocation of forward-looking common costs. Per-unit costs shall be derived from
total costs using reasonably accurate "fill factors" (estimates of the
proportion of a facility that will be "filled" with network usage); that is,
the per-unit costs associated with a particular element must be derived by
dividing the total cost associated with the element by a reasonable projection
of the actual total usage of the element. Directly attributable forward-looking
costs include the incremental costs of facilities and operations that are
dedicated to the element. Such costs typically include the investment costs and
expenses related to primary plant used to provide that element. Directly
attributable forward-looking costs also include the incremental costs of shared
facilities and operations. Those costs shall be attributed to specific elements
to the greatest extent possible. n1688 For example, the costs of conduits shared
by both transport and local loops,   [*65]   and the costs of central office
facilities shared by both local switching and tandem switching, shall be
attributed to specific elements in reasonable proportions. More broadly, certain
shared costs that have conventionally been treated as common costs (or
overheads) shall be attributed directly to the individual elements to the
greatest extent possible. The forward-looking costs directly attributable to
local loops, for example, shall include not only the cost of the installed
copper wire and telephone poles but also the cost of payroll and other back
office operations relating to the line technicians, in addition to other
attributable costs.

   n1688 Compare Telephone Company-Cable Television Cross-Ownership Rules, CC
Docket No. 87-266, Memorandum Opinion and Order on Reconsideration and Third
Further Notice of Proposed Rulemaking, 10 FCC Rcd 244, 34546 (1994).

   683. Forward-looking cost methodologies, like TELRIC, are intended to
consider the costs that a carrier would incur in the future. Thus, a question
arises whether costs should be computed based on the least-cost, most efficient
network configuration and technology currently available, or whether
forward-looking cost should  [*66]   be computed based on incumbent LECs'
existing network infrastructures, taking into account changes in depreciation
and inflation. The record indicates three general approaches to this issue.
Under the first approach, the forward-looking economic cost for interconnection
and unbundled elements would be based on the most efficient network
architecture, sizing, technology, and operating decisions that are operationally
feasible and currently available to the industry. Prices based on the
least-cost, most efficient network design and technology replicate conditions in
a highly competitive marketplace by not basing prices on existing network design
and investments unless they represent the least-cost system available for
purchase. This approach, however, may discourage facilities-based competition by
new entrants because new entrants can use the incumbent LEC's existing network
based on the cost of a hypothetical least-cost, most efficient network.

   684. Under the second approach, the cost of interconnection and unbundled
network elements would be based on existing network design and technology that
are currently in operation. n1689 Because this approach is not based on a
hypothetical   [*67]   network in the short run, incumbent LECs could recover
costs based on their existing operations, and prices for interconnection and
unbundled elements that reflect inefficient or obsolete network design and
technology. This is essentially an embedded cost methodology.

   n1689 See, e.g., BellSouth reply at 37; Roseville Tel. reply at 8; USTA reply
at 18-19.


   685. Under the third approach, prices for interconnection and access to
unbundled elements would be developed from a forward-looking economic cost
methodology based on the most efficient technology deployed in the incumbent
LEC's current wire center locations. This approach mitigates incumbent LECs'
concerns that a forward-looking pricing methodology ignores existing network
design, while basing prices on efficient, new technology that is compatible with
the existing infrastructure. This benchmark of forward-looking cost and existing
network design most closely represents the incremental costs that incumbents
actually expect to incur in making network elements available to new entrants.
Moreover, this approach encourages facilities-based competition to the extent
that new entrants, by designing more efficient network configurations,   [*68]
are able to provide the service at a lower cost than the incumbent LEC. We,
therefore, conclude that the forward-looking pricing methodology for
interconnection and unbundled network elements should be based on costs that
assume that wire centers will be placed at the incumbent LEC's current wire
center locations, but that the reconstructed local network will employ the most
efficient technology for reasonably foreseeable capacity requirements.

   686. We agree with USTA, Bell Atlantic, and BellSouth that, as a theoretical
matter, the combination of significant sunk investment, declining technology
costs, and competitive entry may increase the depreciation costs and cost of
capital of incumbent LECs. We do not agree, however, that TSLRIC does not or
cannot account for risks that an incumbent LEC incurs because it has sunk
investments in facilities. On the contrary, properly designed depreciation
schedules should account for expected declines in the value of capital goods.
Both AT&T and MCI appear to agree with this proposition. n1690 For example, AT&T
states, "in order to estimate TSLRIC, one must perform a discounted cash flow
analysis of the future costs associated with the decision  [*69]   to invest . .
. . One-time costs associated with the acquisition of capital goods are
amortized over the economic life of the assets using the user cost of capital .
. ., which requires accounting for both expected capital good price changes and
economic depreciation." n1691 Moreover, we are confident that parties to an
arbitration with TELRIC studies can propose specific depreciation rate
adjustments that reflect expected asset values over time.

   n1690 See Letter from Leonard S. Sawicki, Director, FCC Affairs, MCI
Telecommunications Corp. to William F. Caton, Acting Secretary, FCC, July 24,
1996 at Attachment (Depreciation and Capital Recovery Issues: A Response to
Professor Hausrnan), pp.1-3; see also Letter from Richard N. Clarke, AT&T, to
William F. Caton, Acting Secretary, FCC, July 19, 1996 at Attachment (Capital
Recovery Issues in TSLRIC Pricing: Response to Professor Jerry A. Hausman).

   n1691 Letter from Richard N. Clarke, AT&T, to William F. Caton, Acting
Secretary, FCC, July 19, 1996 at Attachment (Capital Recovery Issues in TSLRIC
Pricing: Response to Professor Jerry A. Hausman), p.8.

   687. As noted, we also agree that, as a matter of theory, an increase in risk
[*70]   due to entry into the market for local exchange service can increase a
LEC's cost of capital. We believe that this increased risk can be partially
mitigated, however, by offering term discounts, since long-term contracts can
minimize the risk of stranded investment. In addition, growth in overall market
demand can increase the potential of the incumbent LEC to use some of its
displaced facilities for other purposes. Overall, we think that these factors
can and should be captured in any LRIC model and therefore we do not agree that
this requires a departure from the general principle of forward-looking
cost-based pricing for network elements.



   688. We are not persuaded by USTA's argument that forward looking
methodologies fall to adjust the cost of capital to reflect the risks associated
with irreversible investments and that they are "biased downward by a factor of
three." First, USTA's argument unrealistically assumes that competitive entry
would be instantaneous. The more reasonable assumption of entry occurring over
time will reduce the costs associated with sunk investment. Second, we find it
unlikely that investment in communications equipment is entirely irreversible or
that  [*71]   such equipment would become valueless once facilities-based
competition begins. In a growing market, there most likely would be demand for
at least some embedded telecommunications equipment, which would therefore
retain its value. Third, contractual arrangements between the new entrant and
the incumbent that specifically address USTA's concerns and protect incumbent's
investments during transition can be established.

   689. Finally we are not persuaded that the use by firms of hurdle rates that
exceed the market. cost of capital is convincing evidence that sunk investments
significantly increase a firm's cost of capital. An alternative explanation for
this phenomenon is that the process that firms use to choose among investment
projects results in overestimates of their returns. Firms therefore use hurdle
rates in excess of the market cost of capital to account for these
overestimates. n1692

   n1692 See Richard Thaler, The Winner's Curse, 2 J. Econ. Perspectives 201
(1988); Keith Brown, Note on the Apparent Bias of Net Revenue Estimates for
Capital Investment Projects, 29 J. Fin. 1215-16 (1974); Daniel Kahneman and
Daniel Lovallo, Timid Choices, Bold Forecasts, 39 Management Science 17, 28
(1993). In addition, we note that Hausman's arguments that TSLRIC method
underestimate the true cost of an element apply only to the capital expense
associated with an element and not to the operating expense.  [*72]

   690. Summary of TELRIC Methodology. The following summarizes our conclusions
regarding setting prices of interconnection and access to unbundled network
elements based on the TELRIC methodology for such elements. The increment that
forms the basis for a TELRIC study shall be the entire quantity of the network
element provided. As we have previously stated, all costs associated with the
providing the element shall be included in the incremental cost. Only
forward-looking, incremental costs shall be included in a TELRIC study. Costs
must be based on the incumbent LEC's existing wire center locations and most
efficient technology available.


   691. Any function necessary to produce a network element must have an
associated cost. The study must explain with specificity why and how specific
functions are necessary to provide network elements and how the associated costs
were developed. Only those costs that are incurred in the provision of the
network elements in the long run shall be directly attributable to those
elements. Costs must be attributed on a cost-causative basis. Costs are
causally-related to the network element being provided if the costs are incurred
as a direct result of  [*73]   providing the network elements, or can be
avoided, in the long ran, when the company ceases to provide them. Thus, for
example, the forward-looking costs of capital (debt and equity) needed to
support investments required to produce a given element shall be included in the
forward-looking direct cost of that element. Directly attributable costs shall
include costs such as certain administrative expenses, which have traditionally
been viewed as common costs, if these costs vary with the provision of network
elements. Retailing costs, such as marketing or consumer billing costs
associated with retail services, are not attributable to the production of
network elements that are offered to interconnecting carriers and must not be
included in the forward-looking direct cost of an element.

   692. In a TELRIC methodology, the "long run" used shall be a period long
enough that all costs are treated as variable and avoidable. n1693 This "long
run" approach ensures that rates recover not only the operating costs that vary
in the short run, but also fixed investment costs that, while not variable in
the short term, are necessary inputs directly attributable to providing the
element.

   n1693 See 1 Alfred E. Kahn The Economics of Regulation: Principles and
Institutions 70-71 (1988).  [*74]

   693. States may review a TELRIC economic cost study in the context of a
particular arbitration proceeding, or they may conduct such studies in a
rulemaking and apply the results in various arbitrations involving incumbent
LECs. In the latter case, states must replace any interim rates n1694 set in
arbitration proceedings with the permanent rate resulting from the separate
rulemaking. This permanent rate will take effect at or about the time of the
conclusion of the separate rulemaking and will apply from that time forward.

   n1694 See infra, Section VII.C., discussing default proxy price ceilings and
ranges.

   694. Forward-Looking Common Costs. Certain common costs are incurred in the
provision of network elements. As discussed above, some of these costs are
common to only a subset of the elements or services provided by incumbent LECs.
Such costs shall be allocated to that subset, and should then be allocated among
the individual elements or services in that subset, to the greatest possible
extent. For example, shared maintenance facilities and vehicles should be
allocated only to the elements that benefit from those facilities and vehicles.
Common costs also include costs incurred  [*75]   by the firm's operations as a
whole, that are common to all services and elements (e.g., salaries of
executives involved in overseeing all activities of the business), although for
the purpose of pricing interconnection and access to unbundled elements, which
are intermediate products offered to competing carriers, the relevant common
costs do not include billing, marketing, and other costs attributable to the
provision of retail service. n1695 Given these common costs, setting the price
of each discrete network element based solely on the forward-looking incremental
costs directly attributable to the production of individual elements will not
recover the total forward-looking costs of operating the wholesale network.
n1696 Because forward-looking common costs are consistent with our
forward-looking, economic cost paradigm, a reasonable measure of such costs
shall be included in the prices for interconnection and access to network
elements.

   n1695 See infra, Section VIII.B., describing "avoided costs" in the resale
context.

   n1696 See, e.g., AT&T comments at 61-66; Teleport comments at 47-48.


   695. The incumbent LECs generally argue that common costs are quite
significant,   [*76]   n1697 while several other parties maintain that these
amounts are minimal. n1698 Because the unbundled network elements correspond,
to a great extent, to discrete network facilities, and have different operating
characteristics, we expect that common costs should be smaller than the common
costs associated with the long-run incremental cost of a service. We expect that
many facility costs that may be common with respect to the individual services
provided by the facilities can be directly attributed to the facilities when
offered as unbundled network elements. Moreover, defining the network elements
at a relatively high level of aggregation, as we have done, n1699 should also
reduce the magnitude of the common costs. A properly conducted TELRIC
methodology will attribute costs to specific elements to the greatest possible
extent, which will reduce the common costs. Nevertheless, there will remain some
common costs that must be allocated among network elements and interconnection
services. For example, at the sub-element level of study (e.g., identifying the
respective costs of 2-wire loops, 4-wire loops, ISDN loops, and so on), common
costs may be a significant proportion of all the  [*77]   costs that must be
recovered from sub-elements. Given the likely asymmetry of information regarding
network costs, we conclude that, in the arbitration process, incumbent LECs
shall have the burden to prove the specific nature and magnitude of these
forward-looking common costs.

   n1697 See, e.g., PacTel reply at 27-28; see also Cincinnati Bell reply at 10;
USTA comments at Attachment 1 (Affidavit of Jerry A. Hausman), p.4 n.1.

   n1698 See, e.g., Competition Policy Institute comments at 19; MCI comments at
66; Texas Public Utility Counsel comments at 24.

   n1699 See supra, Section V., discussing unbundling requirements.

   696. We conclude that forward,looking common costs shall be allocated among
elements and services in a reasonable manner, consistent with the
pro-competitive goals of the 1996 Act. One reasonable allocation method would be
to allocate common costs using a fixed allocator, such as a percentage markup
over the directly attributable forward-looking costs. We conclude that a second
reasonable allocation method would allocate only a relatively small share of
common costs to certain critical network elements, such as the local loop and
collocation, that are most  [*78]   difficult for entrants to replicate promptly
(i.e., bottleneck facilities). Allocation of common costs on this basis ensures
that the prices of network elements that are least likely to be subject to
competition are not artificially inflated by a large allocation of common costs.
On the other hand, certain other allocation methods would not be reasonable. For
example, we conclude that an allocation methodology that relies exclusively on
allocating common costs in inverse proportion to the sensitivity of demand for
various network elements and services may not be used. n1700 We conclude that
such an allocation could unreasonably limit the extent of entry into local
exchange markets by allocating more costs to, and thus raising the prices of,
the most critical bottleneck inputs, the demand for which tends to be relatively
inelastic. Such an allocation of these costs would undermine the pro-competitive
objectives of the 1996 Act.


   n1700 See Frank P. Ramsey, A Contribution to the Theory of Taxation, 37 Econ.
J. 47 (1927); see generally Kenneth E. Train, Optimal Regulation: The Economic
Theory of Natural Monopoly 115-40 (1992) (discussing efficiency properties of
Ramsey prices); Bridger M. Mitchell & Ingo Vogelsang, Telecommunications
Pricing: Theory and Practice 43-61 (1991). The sensitivity of demand is measured
by the elasticity of demand, which is defined as the percentage change in the
quantity of a service demanded for a one per cent change in price.  [*79]
   697. We believe that our treatment of forward-looking common costs will
minimize regulatory burdens and economic impact for all parties involved in
arbitration of agreements for interconnection and access to unbundled elements,
and will advance the 1996 Act's pro-competitive objectives for local exchange
and exchange access markets. n1701 In our decisionmaking, we have considered the
economic impact of our rules in this section on small incumbent LECs. For
example, although opposed to the use of a forward-looking, economic cost
methodology, small incumbent LECs favor the recovery of joint and common costs
in the event the Commission adopts forward-looking cost methodology. We are
adopting such an approach. Moreover, the cost-based pricing methodology that we
are adopting is designed to permit incumbent LECs to recover their economic
costs of providing interconnection and unbundled elements, which may minimize
the economic impact of our decisions on incumbent LECs, including small
incumbent LECs. We also note that certain small incumbent LECs are not subject
to our rules under section 251(f)(1) of the 1996 Act, unless otherwise
determined by a state commission, and certain other small  [*80]   incumbent
LECs may seek relief from their state commissions from our rules under section
251(f)(2) of the 1996 Act. n1702

   n1701 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

   n1702 47 U.S.C. @ 251(f).

   698. We further conclude that, for the aggregate of all unbundled network
elements, incumbent LECs must be given, a reasonable opportunity to recover
their forward-looking common costs attributable to operating the wholesale
network. In no instance should prices exceed the stand-alone cost for a specific
element, and in most cases they should be below stand-alone costs. Stand-alone
costs are defined as the forward-looking cost that an efficient entrant would
incur in providing a given element or any combination of elements. No price
higher than stand-alone cost could be sustained in a market from which entry
barriers were completely absent. Where there are few common costs, there is
likely to be only a minimal difference between the forward-looking costs that
are directly attributable to the particular element, which excludes these costs,
and stand-alone cost, which includes all of them. Network elements should not,
however, be priced at levels that would enable the  [*81]   incumbent LEC to
recover the same common costs multiple times from different elements. Any
multiple recovery would be unreasonable and thus in violation of the statutory
standard. Further, we note that the sum of the direct costs and the
forward-looking common costs of all elements will likely differ from the
incumbent LEC's historical, fully distributed costs.


   699. Reasonable Return on Investment and "Profit." Section 252(d)(1) states
that rates for interconnection and access to unbundled elements "may include a
reasonable profit." n1703 We find that the TELRIC pricing methodology we are
adopting provides for such a reasonable profit and thus no additional profit is
justified under the statutory language. We note there are two types of profit.
First, in plain English, profit is defined as "the excess of returns over
expenditure in a transaction or a series of transactions." n1704 This is also
known as a "normal" profit, which is the total revenue required to cover all of
the costs of a firm, including its opportunity costs. n1705 Second, there is
"economic" profit, which is any return in excess of normal profit. n1706 Thus,
for example, if the normal return in an industry is 10   [*82]   percent and a
firm earns a return of 14 percent, the economic profit for that firm is 4
percent. Economic is also referred to as "supranormal" profit. We conclude
that the definition of "normal" profit is embodied in "reasonable profit" under
Section 252(d)(1).

   n1703 47 U.S.C. @ 252(d)(1).

   n1704 Webster's New Collegiate Dictionary 931 (10th ed. 1994).

   n1705 See David W. Pearce, The MIT Dictionary of Modern Economics (1994) at
310.

   n1706 Id. at 415.

   700. The concept of normal profit is embodied in forward-looking costs
because the forward-looking cost of capital, i.e., the cost of obtaining debt
and equity financing, is one of the forward-looking costs of providing the
network elements. This forward-looking cost of capital is equal to a normal
profit. We conclude that allowing greater than normal profits would not be
"reasonable" under sections 251(c) and 252(d)(1). n1707 Thus, contrary to the
arguments put forth by several incumbent LECs, we find that adding an additional
measure of profit to the risk-adjusted cost of capital n1708 in setting the
prices for interconnection and access to unbundled elements would violate the
requirements of sections 251(c) and 252(d)(1)   [*83]   of the 1996 Act.

   n1707 We note that our interpretation is consistent with existing Supreme
Court precedent concerning what constitutes a reasonable rate of return for a
regulated public utility. For example, in Bluefield Water Works, the Court
stated:

   A public utility is entitled to such rates as will permit it to earn a return
on the value of the property which it employs for the convenience of the public
equal to that generally being made at the same time and in the same general part
of the country on investments in other business undertakings which are attended
by corresponding risks and uncertainties; but it has no constitutional right to
profits such as are realized or anticipated in highly profitable enterprises or
speculative ventures.



Bluefield Water Works & Improvement Co. v. Public Service Comm'n of West
Virginia, 262 U.S. 679, 692-93 (1923). Similarly, in FPC v. Hope Natural Gas,
the Court stated:

. . . it is important that there be enough revenue not only for operating
expenses but also for the capital costs of the business. These include service
on the debt and dividends on the stock . . . By that standard the return to the
equity owner should be commensurate with risks on investments in other
enterprises having corresponding risks. That return, moreover, should be
sufficient to assure confidence in the financial integrity of the enterprise, so
as to maintain its credit and to attract capital.




Federal Power Comm'n v. Hope Natural Gas Co., 320 U.S. 591, 603 (1994) (Hope
Natural Gas). Cf., Charles F. Phillips, Jr., The Economics of Regulation 260
(Rev. ed. 1965) (". . . a regulated company must be afforded the opportunity not
only of assuring its financial integrity so that it can maintain its credit
standing and attract additional capital as needed, but also for earnings
comparable to those of other companies having corresponding risks.").  [*84]

   n1708 See supra, this Section, for a discussion of risk-adjusted cost of
capital.

   701. Possible accounting losses from the sale of interconnection and
unbundled network elements using a reasonable forward-looking cost-based
methodology do not necessarily indicate that incumbent LECs are being denied a
"reasonable profit" under the statute. The use of a forward-looking, economic,
cost-based pricing methodology, including a reasonable allocation of legitimate
joint and common costs, will permit incumbent LECs the opportunity to earn a
reasonable return on their investment in network elements. Finally, contrary to
PacTel's argument, and as discussed below in detail, we conclude that our
forward-looking cost-based pricing methodology is consistent with the Fifth
Amendment and is not confiscatory.

   702. Based on the current record, we conclude that the currently authorized
rate of return at the federal or state level is a reasonable starting point for
TELRIC calculations, and incumbent LECs bear the burden of demonstrating with
specificity that the business risks that they face in providing unbundled
network elements and interconnection services would justify a different
risk-adjusted  [*85]   cost of capital or depreciation rate. These elements
generally are bottleneck, monopoly services that do not now face significant
competition. We recognize that incumbent LECs are likely to face increased risks
given the Overall increases in competition in this industry, which generally
might warrant an increased cost of capital, but note that, earlier this year, we
instituted a preliminary inquiry as to whether the currently authorized federal
11.25 percent rate of return is too high given the current marketplace cost of
equity and debt. n1709 On the basis of the current record, we decline to engage
in a time-consuming examination to determine a new rate of return, which may
well require a detailed proceeding. States may adjust the cost of capital if a
party demonstrates to a state commission that either a higher or lower level of
cost of capital is warranted, without that commission conducting a
"rate-of-return or other rate based proceeding." n1710 We note that the
risk-adjusted cost of capital need not be uniform for all elements. We intend to
re-examine the issue of the appropriate risk-adjusted cost of capital on an
ongoing basis, particularly in light of the state commissions'   [*86]
experiences in addressing this issue in specific situations.

   n1709 See Common Carrier Bureau Sets Pleading Schedule in Preliminary Rate of
Return Inquiry, Public Notice, 11 FCC Rcd 3651 (Com. Car. Bur. 1996).

   n1710 47 U.S.C. @ 252(d)(1)(A)(i).

   703. We disagree with the conclusion that, when there are mostly sunk costs,
forward-looking economic costs should not be the basis for pricing
interconnection elements. The TELRIC of an element has three components, the
operating expenses, the depreciation cost, n1711 and the appropriate
risk-adjusted cost of capital. We conclude that an appropriate calculation of
TELRIC will include a depreciation rate that reflects the true changes in
economic value of an asset and a cost of capital that appropriately reflects the
risks incurred by an investor. Thus, even in the presence of sunk costs,
TELRIC-based prices are an appropriate pricing methodology.



   n1711 Depreciation is the method of recognizing as an expense the cost of a
capital investment. Properly calculated economic depreciation is a periodic
reduction in the book value of an asset that makes the book value equal to its
economic or market value.

   (b) Cost Measures Not Included  [*87]   in Forward-Looking Cost Methodology

   704. Embedded Costs. We read section 252(d)(1)(A)(i) to prohibit states from
conducting traditional rate-of-return or other rate-based proceedings to
determine rates for interconnection and access to unbundled network elements. We
find that the parenthetical, "(determined without reference to a rate-of-return
or other rate-based proceeding)," n1712 does not further define the type of
costs that may be considered, but rather specifies a type of proceeding that may
not be employed to determine the cost of interconnection and unbundled network
elements. The legislative history demonstrates that Congress was eager to set in
motion expeditiously the development of local competition and intended to avoid
imposing the costs and administrative burdens associated with a traditional rate
case. Prior to the joint conference, the Senate version of the 1996 Act
contained the parenthetical language. n1713 In addition, the Senate version of
the 1996 Act eliminated rate-of-return regulation, n1714 as did the House
version. n1715 Conferees removed the provisions eliminating rate-of-return
regulation, but retained the parenthetical.

   n1712 47 U.S.C. @ 252(d)(1)(A)(i).  [*88]

   n1713 S. 652, 104th Cong., 1st Sess. @ 251(d)(6)(A) (1995) ("the charge (A)
shall be (i) based on the cost (determined without reference to a rate-of-return
or other rate-based proceeding) of providing the unbundled element . . . .").

   n1714 Id. at @ 301(a)(3) ("Rate of Return Regulation Eliminated -- (A) In
instituting the price flexibility required under paragraph (1) the Commission
and the States shall establish alternative forms of regulation for Tier 1
telecommunications carriers that do not include regulation of the rate of return
earned by such carrier . . . .").

   n1715 H.R. 1555, 104th Cong., 1st Sess. @ 248(b) (1995) ("Abolition of
Rate-of-Return Regulation -- Notwithstanding any other provision of law, to the
extent that a carrier has complied with sections 242 and 244 of this part, the
Commission, with respect to rates for interstate or foreign communications, and
State commissions, with respect to rates for intrastate communications, shall
not require rate-of-return regulation.").


   705. Section 252(d)(1)(A)(i) does not specify whether historical or embedded
costs should be considered or whether only forward-looking costs should be
considered in setting arbitrated  [*89]   rates. We are not persuaded by
incumbent LEC arguments that prices for interconnection and unbundled network
elements must or should include any difference between the embedded costs they
have incurred to provide those elements and their current economic costs.
Neither a methodology that establishes the prices for interconnection and access
to network elements directly on the costs reflected in the regulated books of
account, nor a price based on forward looking costs plus an additional mount
reflecting embedded costs, would be consistent with the approach we are
adopting. The substantial weight of economic commentary in the record suggests
that an "embedded cost"-based pricing methodology would be pro-competitor -- in
this case the incumbent LEC -- rather than pro-competition. n1716 We therefore
decline to adopt embedded costs as the appropriate basis of setting prices for
interconnection and access to unbundled elements. Rather, we reiterate that the
prices for the interconnection and network elements critical to the development
of a competitive local exchange should be based on the pro-competition,
forward-looking, economic costs of those elements, which may be higher or lower
[*90]   than historical embedded costs. Such pricing policies will best ensure
the efficient investment decisions and competitive entry contemplated by the
1996 Act, which should minimize the regulatory burdens and economic impact of
our decisions on small entities. n1717

   n1716 See, e.g., Ad Hoc Telecommunications Users' Committee reply at Appendix
A (Interconnection Pricing Standards for Monopoly Rate Elements in a Potentially
Competitive Local Telecommunications Market), p.4; ALTS comments at Attachment B
(Competitive Pricing of Interconnection, Unbundled Elements, and Collocation),
pp.28-29; AT&T reply at Appendix B (Reply Affidavit of William J. Baumol, Janusz
A. Oralover, and Robert D. Willig), pp.3-5; Competition Policy Institute
comments at 18-19; DJ comments at 30-31.

   n1717 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

   706. Incumbent LECs contend generally that, in order to ensure they will
recover their total investment costs and earn a profit, they must recover
embedded costs. These costs, they argue, were incurred under federal and
regulatory oversight and therefore should be recoverable. n1718 We are not
convinced by the incumbent LECs' principal arguments for  [*91]   recognizing
embedded cost in setting section 251 pricing rules. Even if the incumbent LECs'
contention is correct, increasing the rates for interconnection and unbundled
elements offered to competitors would interfere with the development of
efficient competition, and is not the proper remedy for any past
under-depreciation. Moreover, contrary to assertions by some incumbent LECs,
regulation does not and should not guarantee full recovery of their embedded
costs. Such a guarantee would exceed the assurances that we or the states have
provided in the past. n1719 We have considered the economic impact of precluding
recovery of small incumbent LECs' embedded costs. n1720 We do not believe that
basing the prices of interconnection and unbundled elements on an incumbent
LEC's embedded costs would advance the pro-competitive goals of the statute. We
also note that certain small incumbent LECs are not subject to our rules under
section 251(f)(1) of the 1996 Act, unless otherwise determined by a state
commission, and certain other small incumbent LECs may seek relief from their
state commissions from our rules under section 251(f)(2) of the 1996 Act. n1721

   n1718 See, e.g., Ameritech reply at 31; BellSouth comments at 57; Lincoln
Tel. comments at 16-17.  [*92]

   n1719 See In the Matter of the Applications of Pacific Bell, Order and
Authorization, 10 FCC Rcd 12448, 12502-12503 (1995).

   n1720 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

   n1721 47 U.S.C. @ 251(f).


   707. We acknowledge that some incumbent LECs may have incurred certain
embedded costs reasonably before the passage of the 1996 Act, based on different
regulatory regimes. Some incumbent LECs may assert that they have made certain
historical investments required by regulators that they have been denied a
reasonable opportunity to" recover in the past and that the incumbent LECs may
no longer have a reasonable opportunity to recover in the new environment of the
1996 Act. The record before us, however, does not support the conclusion that
significant residual embedded costs will necessarily result from the
availability of network elements at economic costs. To the extent that any such
residual consists of costs of meeting universal service obligations, the
recovery of such costs can and should be considered in our ongoing universal
service proceeding. n1722 To the extent a significant residual exists within the
interstate jurisdiction that does not fall within  [*93]   the ambit of section
254, we intend that to address that issue in our upcoming proceeding on access
reform.

   n1722 See Universal Service NPRM at para. 32.

   708. Opportunity Cost -- Efficient Component Pricing Rule. A number of
incumbent LECs advocate using the "efficient component pricing role" (ECPR) to
set the prices that' incumbent LECs charge new entrants for inputs required to
produce the same retail services the incumbent produces. Under the ECPR, the
price of an input should be equal to the incremental cost of the input plus the
opportunity cost that the incumbent carrier incurs when the new entrant provides
the services instead of the incumbent. The opportunity cost, which is computed
as revenues less all incremental costs, represents both profit and contribution
to common costs of the incumbent, given the existing retail prices of the
services being sold.

   709. We conclude that ECPR is an improper method for setting prices of
interconnection and unbundled network elements because the existing retail
prices that would be used to compute incremental opportunity costs under ECPR
are not cost-based. Moreover, the ECPR does not provide any mechanism for moving
prices towards  [*94]   competitive levels; it simply takes prices as given. The
record indicates that both incumbents and new entrants agree that retail prices
are not based on costs. Incumbents generally argue that local residential retail
prices are below costs while new entrants contend that they exceed competitive
levels. n1723 In either case, application of ECPR would result in input prices
that would be either higher or lower than those which would be generated in a
competitive market and would not lead to efficient retail pricing.

   n1723 See, e.g., Ameritech comments at 62.

   710. In markets where retail prices exceed competitive levels, entry would
take place if network element prices were set at efficient competitive levels.
The ECPR, however, will serve to discourage competition in these very markets
because it relies On the prevailing retail price in setting the price which new
entrants pay the incumbent for inputs. While ECPR establishes conditions for
efficient entry given existing retail prices, as its advocates contend, the ECPR
provides no mechanism that will force retail prices to their competitive levels.
We do not believe that Congress envisioned a pricing methodology for
interconnection  [*95]   and network elelments that would insulate incumbent
LECs' retail prices from competition. Instead, Congress specifically determined
that input prices should be based on costs because this would foster competition
in the retail market. Therefore, we reject the use of ECPR for establishing
prices for interconnection and unbundled elements.


   711. As discussed above, the record in this docket shows that end user prices
are not cost-based. In Open Video Systems, in contrast, we did not find that
there would be a problem with the determination of end user prices. n1724 We
concluded that "use of [an ECPR] approach is appropriate in circumstances where
the pricing is applicable [sic] to a new market entrant (the open video system
operator) that will face competition from an existing incumbent provider (the
incumbent cable operator), as opposed to circumstances where the pricing is used
to establish a rate for an essential input service that is charged to a
competing new entrant by an incumbent provider." n1725 In addition, in Open
Video Systems, we concluded that the ECPR is appropriate because it encourages
entry for open video system operators and also enhances the availability of
carriage  [*96]   for unaffiliated programmers. n1726 The ECPR generally
protects the provider's profits and provides opportunities for third parties to
use the provider's inputs. The ECPR does not provide a mechanism to drive retail
prices to competitive levels, however. In Open Video Systems, we wanted to
encourage entry by open video system providers and to encourage them to have
incentives to open their systems to unaffiliated programmers. Here, our goal is
to ensure that competition between providers, including third party providers
using interconnection and unbundled elements, will drive prices toward
competitive levels and thus use of the ECPR is inappropriate.

   n1724 Implementation of Section 302 of the Telecommunications Act of 1996 --
Open Video Systems, CS Docket No. 96-46, Second Report and Order, FCC 96-249
(rel. June 3, 1996) (Open Video Systems).

   n1725 Id. at 127.

   n1726 Id.

   712. Universal Service Subsidies. We conclude that funding for any universal
service mechanisms adopted in the universal service proceeding may not be
included in the rates for interconnection, network elements, and access to
network elements that are arbitrated by the states under sections 251 and
[*97]   252. Sections 254(d) and 254(e) of the 1996 Act mandate that universal
service support be recovered in an equitable and nondiscriminatory-manner from
all providers of telecommunications services. n1727 We conclude that permitting
states to include such costs in rates arbitrated under sections 251 and 252
would violate that requirement by requiring carriers to pay specified portions
of such costs solely because they are purchasing services and elements under
section 251. Section 252(d)(1) requires that rates for interconnection, network
elements, and access to network elements reflect the costs of providing those
network elements, not the costs of supporting universal service.

   n1727 Joint Explanatory Statement at 131 ("In keeping with the conferees'
intent that universal service support should be clearly identified, [section
254(e)] states that such support should be made explicit . . .").


   713. Section 254(f) provides that a state may adopt equitable,
nondiscriminatory, specific, and predictable mechanisms to advance universal
service within that state. n1728 If a state collects universal service funding
in rates for elements and services pursuant to sections 251 and 252, it will
[*98]   be imposing non-cost based charges in those rates. Including non-cost
based charges in the rates for interconnection and unbundled elements is
inconsistent with our rules implementing sections 251 and 252 which require that
these rates be cost-based. It is also inconsistent with the requirement of
section 254(f) that telecommunications carriers contribute to state universal
service on a nondiscriminatory basis, because telecommunications carriers
requesting interconnection or access to unbundled network elements will be
required to make contributions to universal service support through such
surcharges. n1729 States may not, therefore, include universal service support
funding in the rates for elements and services pursuant to sections 251 and 252,
nor may they implement mechanisms that have the same effect. For example, states
may not fund universal service support by imposing higher rates for
interconnection, unbundled elements, or transport and termination on carriers
that offer service to different types of customers or different geographic
areas. To the extent that New York's "pay or play" system funds universal
service in this manner, it violates sections 251,252, and 254 of  [*99]   the
1996 Act. Nothing in the 1996 Act or in this Order, however, precludes a state
from adopting a universal service funding mechanism, whether interim or
otherwise, if such funds are collected in accordance with section 254(f) on an
"equitable and nondiscriminatory basis" through "specific, predictable, and
sufficient mechanisms that do not rely on or burden Federal universal service
support mechanisms." n1730

   n1728 47 U.S.C. @ 254(f).

   n1729 See infra, Section VII.D.3., discussing discrimination.

   n1730 47 U.S.C. @ 254(f).

   714. Our decision here does not exempt carriers purchasing elements or
services under section 251 from contributing to (or possibly receiving)
universal service support. Rather, the recovery of universal service support
costs from telecommunications carriers, including carriers requesting unbundled
network elements, will be governed by section 254 of the 1996 Act. Federal
universal service support mechanisms will be determined by our decisions reached
in CC Docket 96-45, based on the recommendations of the Federal/State Universal
Service Joint Board, and states may adopt additional universal service support
mechanisms consistent with section 254(f).   [*100]

   715. We are mindful that the requirements of the 1996 At may be disruptive to
existing state universal service support mechanisms during the period commencing
with this order and continuing until we complete our universal service
proceeding to implement section 254. As discussed in the subsection immediately
below, we permit incumbent LECs to continue to recover certain non-cost-based
interstate access charge revenues for a limited period of time, largely because
of concerns about possible deleterious impacts on universal service. We also
authorize incumbent LECs, for a similar limited period of time, to continue to
recover explicit intrastate universal service subsidy revenues based on
intrastate access charges. This mechanism minimizes any possibility that
implementation of sections 251 and 252 will unduly harm universal service during
the interim period prior to completion of our universal service and access
reform proceedings. Because we conclude this action should adequately provide
for the continuation of a portion of existing subsidy flows during a transition
period until completion of our proceeding implementing section 254, we decline
to permit any additional funding of   [*101]   universal service support through
rates for interconnection, unbundled elements, and transport and termination
during the interim period.

   716. Interim Application of Access Charges to Purchasers of Unbundled Local
Switching Element. In the introduction of this Order, we emphasize that
implementation of section 251 of the 1996 Act is integrally related to both


universal service reform as required under section 254, and to reform of the
interstate access charge system. n1731 In order to achieve pro-competitive,
deregulatory markets for all telecommunications services, we must create a new
system of funding universal service that is specific, explicit, predictable,
sufficient, and competitively neutral, We also must move access charges to more
cost-based and economically efficient levels. We intend to fulfill both of these
goals in the coming months, by completing our pending universal service
proceeding to implement section 254 by our statutory deadline of May 1997, and
by addressing access charge issues in an upcoming access reform proceeding. The
1996 Act, however, requires us to adopt rules implementing section 251 by August
1996. We are concerned that implementation of the requirements  [*102]   of
section 251 now, without taking into account the effects of the new rules on our
existing access charge and universal service regimes, may have significant,
immediate, adverse effects that were neither intended nor foreseen by Congress.

   n1731 See supra, Section I.B.

   717. Specifically, as we conclude above, the 1996 Act permits
telecommunications carriers that purchase access to unbundled network elements
from incumbent LECs to use those elements to provide telecommunications
services, including the origination and termination of interstate calls. Without
further action on our part, section 251 would allow entrants to use those
unbundled network facilities to provide access services to customers they win
from incumbent LECs, without having to pay access charges to the incumbent LECs.
This result would be consistent with the long term outcome in a competitive
market. In the short term, however, while other aspects of our regulatory regime
are in the process of being reformed, such a change may have detrimental
consequences.

   718. The access charge system includes non-cost-based components and elements
that at least in part may represent subsidies, such as the carrier common
[*103]   line charge (CCLC) and the transport interconnection charge (TIC). The
CCLC recovers part of the allocated interstate costs for incumbent LECs to
provide local loops to end users. In the universal service NPRM, we observed
that the CCLC may result in higher-volume toll users paying rates that exceed
cost, and some customers pay