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 paying rates that are below cost. We sought comment on
whether that subsidy should be continued, and on whether and how it should be
restructured. n1732 The nature of most of the revenues recovered through the TIC
is unclear and subject to dispute, although a portion of the TIC is associated
with certain costs related to particular transport facilities. Although the TIC
was not created to subsidize local rates, some parties have argued in the
Transport proceeding and elsewhere that some portion of the revenues now
recovered through the TIC may be misallocated local loop or intrastate costs
that operate to support universal service. n1733 In the forthcoming access
reform proceeding, we intend to consider the appropriate disposition of the TIC,
including the development of cost-based transport rates as directed by the
United States Court of Appeals for the District  [*104]   of Columbia Circuit in
Competitive Telecommunications Association v. FCC (CompTel v. FCC). n1734

   n1732 Universal Service NPRM at paras. 113-14.


   n1733 Transport Rate Structure and Pricing, CC Docket No. 91-213, Report and
Order and Further Notice of Proposed Rulemaking, 7 FCC Rcd 7006, 7065-7066
(1992) (First Transport Order). Cf. Letter from Bruce K. Cox, Government Affairs
Director, AT&T, to William F. Caton, Acting Secretary, FCC, September 7, 1995
(filed in CC Docket No. 91-213) (suggesting that TIC revenues not allocable to
specific transport facilities may represent misallocated common line costs).

   n1734 Competitive Telecommunications Association v. FCC, No. 96-1168 (D.C.
Cir. July 5, 1996).

   719. Without a temporary mechanism such as the one we adopt below, the
implementation of section 251 would permit competitive local service providers
that also provide interstate long-distance service to avoid totally the CCLC and
the TIC, which in part represent contributions toward universal service, by
serving their local customers solely through the use of unbundled network
elements rather than through resale. We believe that allowing such a result
before we have reformed  [*105]   our universal service and access charge
regimes would be undesirable as a matter of both economics and policy, because
carrier decisions about how to interconnect with incumbent LECs would be driven
by regulatory distortions in our access charge rules and our universal service
scheme, rather than the unfettered operation of a competitive market. Because of
our desire to err on the side of caution where universal service may be
implicated, we conclude that some action is needed during the interim period
before we complete our access reform and universal service proceedings.

   720. We conclude that we should establish a temporary transitional mechanism
to help complete all of the steps toward the pro-competitive goal of the 1996
Act, including the implementation of a new, competitively-neutral system to fund
universal service and a comprehensive review of our system of interstate access
charges. Therefore, for a limited period of time, incumbent LECs may recover
from interconnecting carriers the CCLC and a charge equal to 75 percent of the
TIC for all interstate minutes traversing the incumbent LECs' local switches for
which the interconnecting carriers pay unbundled local switching   [*106]
element charges. Incumbent LECs may recover these charges only until the
earliest of: (1) June 30, 1997; (2) the effective date of final decisions by the
Commission in both the universal service and access reform proceedings; or (3)
if the incumbent LEC is a BOC, the date on which that BOC is authorized under
section 271 of the 1996 Act to offer in-region interLATA service. The end date
for BOCs that are authorized to offer interLATA service shall apply only to the
recovery of access charges in those states in which the BOC is authorized to
offer such service.


   721. We tentatively concluded in the NPRM that purchasers of unbundled
network elements should not be required to pay access charges. We reaffirm our
conclusion above in our discussion of unbundled network elements that nothing on
the face of sections 251 (c)(3) and 252(d)(1) compels telecommunications
carriers that use unbundled elements to pay these charges, nor limits these
carriers' ability to use unbundled elements to originate or terminate interstate
calls, and that payment of rates based on TELRIC plus a reasonable allocation of
common costs, pursuant to section 251 (d)(1), represents full compensation to
the incumbent  [*107]   LEC for use of the network elements that
telecommunications carriers purchase. Because of the unique situation described
in the preceding paragraphs, however, we conclude, contrary to our proposal in
the NPRM, that during a time-limited period, interconnecting carriers should not
be able to use unbundled elements to avoid access charges in all cases. As
detailed below, this temporary mechanism will apply only to carriers that
purchase the local switch as an unbundled network element, and use that element
to originate or terminate interstate traffic. n1735 We are applying these
transitional charges to the unbundled local switching element, rather than to
any other network elements, because such an approach is most closely analogous
to the manner in which the CCLC and TIC are recovered in the interstate access
regime. Currently, the CCLC and TIC apply to interstate switched access minutes
that traverse incumbent LECs' local switches. Applying the CCLC and 75 percent
of the TIC to the unbundled local switching element is consistent with our goal
of minimizing disruptions while we reform our universal service system and
consider changes to our access charge mechanisms. Moreover, the CCLC  [*108]
and the TIC are recovered on a per-minute basis, and the local switch is the
primary point at which incumbent LECs are capable of recording interstate
minutes for traffic associated with end user customers of requesting carriers.

   n1735 As discussed infra, carriers that choose to enter a local market
through resale of an incumbent LEC's intrastate local exchange service will pay
interstate and intrastate access charges to originate and terminate toll traffic
for end user customers that purchase that resold local exchange service.

   722. We have crafted this short-term continuation of certain access charge
revenue flows to minimize the possibility that incumbent LECs will be able to
"double recover" through access charges the facility costs that new entrants
have already paid to purchase unbundled elements. For that reason, we do not
permit incumbent LECs to assess on purchasers of the unbundled local switching
element any interstate access charges other than the CCLC and 75 percent of the
TIC. The other access charges are all designed to recover the cost of particular
facilities involved in the provision of interstate access services, such as
local switching, dedicated interoffice  [*109]   transport circuits, and tandem
switching. Imposition of these facility-based access charges in addition to the
cost-based charges for comparable network elements established under Section 252
could result in double recovery. The mechanism we establish will ensure that
incentives created by non-cost-based elements of access charges do not result in
harmful consequences prior to completion of access reform and our universal
service proceeding. Imposition of additional access charges is therefore not
necessary. We note that this mechanism serves to minimize the potentially
disruptive effects of our decisions on incumbent LECs, including small incumbent
LECs. n1736

   n1736 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.


   723. For the same reason, we permit incumbent LECs to recover only 75 percent
of the TIC. Some portion of the TIC recovers revenues associated with specific
transport facilities. To the extent that these costs can be identified clearly,
they should not be imposed on new entrants through the TIC. Incumbent LECs will
be fully compensated for any transport facilities that new entrants purchase
from them through the unbundled element rates states establish under  [*110]
252(d)(1), which, as we have stated, must be based on economic cost rather than
access charges. In our interim transport rate restructuring, we explicitly set
the initial tandem switching rate at 20 percent of the interstate revenue
requirement, with the remainder included in the TIC. n1737 In addition, certain
costs of upgrading incumbent LEC networks to support SS7 signaling were
allocated to transport through then-existing separations procedures. In our
interim transport rate restructuring, we did not create any facility-based
charges to recover these costs, n1738 so the associated revenues presumably were
incorporated into the TIC. There may also be other revenues associated with
transport facilities that are recovered today through the TIC. While we are
uncertain of the precise magnitude of these revenues, in our best judgment,
based on the record in the Transport proceeding and other information before
us, we find that it is likely that these revenues approach, but probably do not
exceed 25 percent of the TIC for most incumbent LECs. Thus, we believe that 25
percent is a conservative amount to exclude from the TIC to ensure that
incumbent LECs do not double recover revenues   [*111]   associated with
transport facilities from new entrants. Moreover, the Court in CompTel v. FCC
remanded our Transport decision, in part, because of the inclusion of tandem
switching revenues in the TIC rather than in the rate element for tandem
switching. We find that excluding 25 percent of the TIC represents a reasonable
exercise of our discretion to prevent revenues associated with the tandem
switching revenue requirement from being recovered from purchasers or unbundled
local switching.

   n1737 First Transport Order, 7 FCC Rcd at 7019.

   n1738 First Transport Order, 7 FCC Rcd at 7019.

   724. We strongly emphasize that these charges will apply to purchasers of the
unbundled switching element only for a very limited period, to avoid the
possible harms that might arise if we were to ignore the effects on access
charges and universal service of implementation of section 251. BOCs shall not
be permitted to recover these revenues once they are authorized to offer
in-region interLATA service, because at that time the potential loss of access
charge revenues faced by a BOC most likely will be able to be offset by new
revenues from interLATA services. Moreover, although we do not prejudge
[*112]   the conditions necessary to grant BOC petitions under section 271 to
offer in-region interLATA service, we do decide that BOCs should not be able to
charge the CCLC and the TIC, which are not based on forward-looking economic
costs, to competitors that use unbundled elements under section 251 once they
are authorized to provide in-region interLATA service. Only BOCs are subject to
special restrictions in the 1996 Act to ensure that their entry into the
in-region interLATA market does not have an adverse impact on competition. We
conclude that this additional trigger date after which BOCs may not continue to
receive access charges from purchasers of unbundled local switching is
consistent with this Congressional design.

   725. We have selected June 30, 1997 as an ultimate end date for this
transitional mechanism to coincide with the effective date for LEC annual access
tariffs, and because we believe it is imperative that this transitional
requirement be limited in duration. We can conceive of no circumstances under
which the requirement that certain entrants pay the CCLC or a portion of the TIC
on calls carried over unbundled network elements would be extended further. The
fact that  [*113]   access or universal service reform have not been completed
by that date would not be a sufficient justification, nor would any actual or
asserted harm to the financial status of the incumbent LECs. By June 30, 1997,
the industry will have had sufficient time to plan for and adjust to potential
revenue shifts that may result from competitive entry. Thus, the economic impact
of our decision on competitive local service providers, including those that are
small entities, should be minimized. n1739

   n1739 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.


   726. We believe that we have ample legal authority to implement this
temporary transitional measure, and we find that this approach is consistent
with the letter and spirit of the 1996 Act. We recognize that the CCLC and TIC
have not been developed in accordance with the pricing standards of section
252(d)(1), and that to comply with the 1996 Act, the rates that states establish
for interconnection and unbundled network elements may not include
non-cost-based amounts or subsidies. The 1934 and 1996 Acts do, however, give us
legal authority to determine, for policy reasons, that users of LEC facilities
should pay certain access  [*114]   charges for a period of time. n1740 Section
4(i) of the 1934 Act authorizes the Commission to "perform any and all acts . .
. not inconsistent with this Act, as may be necessary in the execution of its
functions." n1741 Given the extraordinary upheaval in the industry's structure
set in motion by the 1996 Act, and the specific concerns described above, we
believe that a temporary mechanism is necessary in order to ensure that the
policy goals underlying the access charge system and the Communications Act
itself are not undermined. Further, we believe section 251(g) of the 1996 Act
lends support to our decision. As discussed above, section 251(g) does not
require that incumbent LECs continue to receive access charge revenues when
telecommunications carriers use unbundled incumbent LEC network elements to
originate and terminate interstate traffic. That section does, however, provide
evidence of Congressional recognition of the potential tension between existing
interconnection obligations, such as access charges, and the new methods of
interconnection mandated by section 251, and therefore supports our decision to
create a limited-duration mechanism to address this tension.

   n1740 See, e.g., New England Tel. and Tel. Co. v. FCC, 826 F.2d 1101 (D.C.
Cir 1987); North American Telecommunications Association v. FCC, 772 F.2d (7th
Cir. 1085); Lincoln Tel. and Tel. Co. v. FCC, 659 F.2d (D.C. Cir. 1989).
[*115]

   n1741 47 U.S.C. @ 4(i).

   727. The decision of the court in CompTel v. FCC to remand our decision to
adopt the TIC is not inconsistent with this approach. The Court's concern
stemmed, in part, from the inclusion of a portion of the interstate tandem
switching revenue requirement in the TIC. We have excluded from the charges that
purchasers of unbundled local switching must pay a percentage of the TIC that,
at a minimum, includes these allocated tandem switching revenues from the
transitional charges that incumbent LECs may assess on IXCs. n1742 Furthermore,
the Court directed the Commission to develop a cost-based transport rate
structure, or to explain why it chose not to do so. n1743 We intend to fulfill
this obligation in the forthcoming access reform proceeding. The charge equal to
75 percent of the TIC will be applied only as an interim measure for a brief,
clearly-identified period, until that restructuring of access charges is
completed. The court expressly acknowledged that the 1996 Act would have
implications for the access charge system. n1744 For the reasons described
above, we conclude that these effects necessitate temporary application of a
portion of the TIC to   [*116]   entrants that win end user customers from LECs,
and that purchase the local switch as an unbundled element to originate and
terminate interstate and intrastate toll traffic for such end users. In the
access reform proceeding, we intend to determine the appropriate disposition for
these revenues. Until we have had the opportunity to do so, however, we permit
incumbent LECs to recover a transitional charge equal to 75 percent of the TIC
under the limited circumstances described herein.

   n1742 As discussed above, we estimate that the tandem switching, SS7, and
other costs associated with transport facilities now recovered through the TIC
likely do not exceed 25% of the TIC for most incumbent LECs.



   n1743 Competitive Telecommunications Association v. FCC, No. 96-1168 at
26-27.

   n1744 Id. at 12-13.

   728. The interim mechanism we establish here differs from the waiver relief
we have previously granted to NYNEX and Ameritech to permit them to recover
certain interstate access charge revenues through "bulk billing" of revenues to
all interstate switched access customers. n1745 Those orders responded to waiver
requests filed prior to the passage of the 1996 Act. Our responsibility
[*117]   in those proceedings was to determine whether special circumstances
existed, and whether the specific relief requested better served the public
interest than continued application of our general rules. By constrast, the
action we take today addresses industry-wide issues that arise from the new
regime put into place by section 251 of the 1996 Act, which allows states to
establish unbundled network element rates that recover the full unseparated cost
of elements. Our response to the Ameritech and NYNEX waiver petitions does not,
simply because those petitions also concerned access charge recovery, constrain
our decision in this proceeding.

   n1745 See The NYNEX Tel. Cos. Petition for Waiver, Transition Plan to
Preserve Universal Service in a Competitive Environment, Memorandum Opinion and
Order, 10 FCC Rcd 7445 (1995), reconsideration pending (NYNEX USPP Order);
Ameritech Operating Companies Petition for a Declaratory Ruling and Related
Waivers to Establish a New Regulatory Model for the Ameritech Region, Order, FCC
96-58 (released Feb. 15, 1996) (Ameritech Customers First Order).

   729. It would be unreasonable to provide such a transitional mechanism on the
federal level, but to  [*118]   deny similar authority to the states. Therefore,
states may continue existing explicit universal service support mechanisms based
on intrastate access charges for an interim period of a similar brief,
clearly-defined length. During that period, unless decided otherwise by the
state, incumbent LECs may continue to recover such revenues from purchasers of
unbundled local switching elements that use those elements to originate or
terminate intrastate toll calls for end user customers they win from incumbent
LECs. States may terminate these mechanisms at any time. We define mechanisms
based on intrastate access charges as those mechanisms that require purchasers
of intrastate access services from incumbent LECs to pay non-cost-based charges
for those access services on the basis of their intrastate access minutes of
use.

   730. We do not intend, however, that such a transitional mechanism eviscerate
the requirements of sections 252 and 254, which, as we have stated, prohibit
funding of universal service subsidies through rates for interconnection and
unbundled network elements. Mechanisms such as New York's "pay or play" system,
which would impose intrastate access charges on non-access  [*119]   services
rather than allowing incumbent LECs to recover non-cost-based revenues from
purchasers of access services, may not be included in this interim system. Such
a result is justified because state "pay or play" mechanisms do not at present
constitute a significant revenue stream to incumbent LECs, and therefore
elimination of this mechanism is unlikely, in the short term, to have
significant detrimental effects on universal service support.


   731. These state mechanisms must end on the earlier of: (1) June 30, 1997; or
(2) if the incumbent LEC that receives the transitional access charge revenues
is a BOC, the date on which that BOC is authorized under section 271 of the 1996
Act to offer in-region interLATA service. With one exception, the analysis
provided above as to the rationale for the end dates for the transitional
interstate access charge mechanism applies here as well. Because our access
reform proceeding focuses on federal charges, and because the full extent of the
section 254 universal service mechanism remains to be determined in that
proceeding, intrastate access charge-based universal service support mechanisms
should not now be required to terminate upon the completion  [*120]   of those
proceedings.

   732. As with our decision to permit incumbent LECs to continue to receive
certain interstate access charge revenues from some purchasers of unbundled
local switching for a limited period of time, we believe our decision to allow
states to preserve certain intrastate universal service support mechanisms based
on access charges is within our authority under section 251(d)(1) of the 1996
Act, and section 4(i) of the 1934 Act. Moreover, although section 251(g) does
not directly refer to intrastate access charge mechanisms, it would be
incongruous to conclude that Congress was concerned about the effects of
potential disruption to the interstate access charge system, but had no such
concerns about the effects on analogous intrastate mechanisms.

   (c) Fifth Amendment Issues

   733. We conclude that our decision that prices for incumbent LECs' unbundled
elements and interconnection offerings be based on forward-looking economic cost
does not violate the incumbent LECs' rights under the Fifth Amendment of the
Constitution. The Supreme Court has recognized that public utilities owned and
operated by private investors, even though their assets are employed in the
public   [*121]   interest to provide consumers with service, may assert their
rights under the Takings Clause of the Fifth Amendment. n1746 In applying the
Takings Clause to rate setting for public utilities, the Court has stated that
"the guiding principle has been that the Constitution protects utilities from
being limited to a charge for their property serving the public which is so
"unjust" as to be confiscatory." n1747

   n1746 The Fifth Amendment provides that, "private property [shall not] be
taken for public use, without just compensation." U.S. Const. amend. V. See
Duquesne Light Co. v. Barasch, 488 U.S. 299, 307 (1989) (Duquesne).

   n1747 Duquesne, 488 U.S. at 307 (citing Covington & Lexington Turnpike Road
Co. v. Sandford, 164 U.S. 578, 597 (1896)).

   734. The Supreme Court has held that the determination of whether a rate is
confiscatory depends on whether that rate is just and reasonable, and not on
what methodology is used. n1748 In Federal Power Comm'n v. Hope Natural Gas Co.,
the Court upheld the Federal Power Commission's order that required the company
to make a large reduction in wholesale gas rates. The commission based its
determination of a reasonable rate of return on a plant  [*122]   valuation
determined by using a historical cost methodology that was only half as large as
the company's own valuation based on forward-looking reproduction costs. In its
decision, the Court set forth the governing legal standard for determining
whether a rate is constitutional:


Under the statutory standard of "just and reasonable" it is the result reached
not the method employed that is controlling. It is not the theory but the
impact of the rate order which counts. If the total effect of the rate order
cannot be said to be unjust and unreasonable, judicial inquiry under the Act is
at an end. The fact that the method employed to reach that result may contain
infirmities is not then important. n1749

   n1748 Hope Natural Gas, 320 U.S. at 602-603; see also Duquesne; In re Permian
Basin Area Rate Cases, 390 U.S. 747 (1968); Federal Power Commission v. Memphis
Light, Gas & Water Division, 411 U.S. 458 (1973); Jersey Central Power & Light
v. FERC, 810 F.2d 1168 (D.C. Cir. 1987).

   n1749 Hope Natural Gas, 320 U.S. at 602.

   735. The Court went on to explain that, in determining whether a rate is
reasonable, the regulatory body must balance the interests of both the investor
[*123]   and consumer. n1750 "From the investor or company point of view, it is
important that there be enough revenue not only for operating expenses but also
for the capital costs of the business . . . . The return on the equity owner
should be commensurate with returns on investments in other enterprises having
corresponding risks." n1751

   n1750 Id.

   n1751 Id. at 603.

   736. Under sections 251(c)(2) and (3) of the 1996 Act, incumbent LECs must
establish rates for interconnection and unbundled elements that are just and
reasonable. n1752 In adopting the rules that govern those rates, under Hope
Natural Gas we must consider whether the end result of incumbent LEC rates is
just and reasonable. Incumbent LECs argue that establishing a rate structure
that does not permit recovery of historical or embedded costs is confiscatory.
We disagree. As stated above, the Court has consistently held since Hope Natural
Gas that it is the end result, not the method used to achieve that result, that
is the issue to be addressed. n1753 Indeed, the Court has found that the "fixing
of prices, like other applications of the police power, may reduce the value of
the property which is being regulated. But  [*124]   the fact that the value is
reduced does not mean that the regulation is invalid." n1754 Moreover, the Court
has upheld as reasonable changes in ratemaking methodology when the change
resulted in the exclusion of historical costs prudently incurred. n1755 Thus,
the mere fact that an incumbent LEC may not be able to set rates that will allow
it to recover a particular cost incurred in establishing its regulated network
does not, in and of itself, result in confiscation.

   n1752 47 U.S.C. @ 251(c)(2) and (3).

   n1753 See, e.g., Duquesne, 488 U.S. at 310; Hope Natural Gas, 320 U.S. at
602.

   n1754 Hope Natural Gas, 320 U.S. at 601.

   n1755 Duquesne, 488 U.S. at 301-302.


   737. Moreover, Hope Natural Gas requires only that the end result of our
overall regulatory framework provides LECs a reasonable opportunity to recover a
return on their investment. In other words, incumbent LECs' overall rates must
be considered, including the revenues for other services under our
jurisdiction. n1756

   n1756 However, we may not consider incumbent LECs' revenue derived from
services not under our jurisdiction. Smith v. Ill. Bell, 282 U.S. 133 (1930).

   738. In this proceeding, we are establishing  [*125]   pricing rules that
should produce rates for monopoly elements and services that approximate what
the incumbent LECs would be able to charge if there were a competitive market
for such offerings. We believe that a forward-looking economic cost methodology
enables incumbent LECs to recover a fair return on their investment, i.e., just
and reasonable rates. The record does not compel a contrary conclusion. No
incumbent LEC has provided persuasive evidence that prices based on a
forward-looking economic cost methodology would have a significant impact on its
"financial integrity." We further note that at least one federal appellate court
has held incremental cost-based pricing constitutional. n1757

   n1757 Metropolitan Transp. Auth. v. Interstate Commerce Commission, 792 F.2d
287, 297 (2d Cir.), cert. denied, 479 U.S. 1017 (1986).

   739. Incumbent LECs may seek relief from the Commission's pricing methodology
if they provide specific information to show that the pricing methodology, as
applied to them, will result in confiscatory rates. We also do not completely
foreclose the possibility that incumbent LECs will be afforded an opportunity to
recover, to some extent, their embedded costs  [*126]   through a mechanism
separate from rates for interconnection and unbundled network elements. As
stated above, we intend to explore this issue in detail in our upcoming access
reform proceeding.

   740. GTE argues that the proper stand to review our ratemaking methodology is
the just compensation standard generally reserved for takings of property. This
is in effect a contention that the 1996 Act's physical collocation and unbundled
network facility requirements constitute physical occupation of their property
that should be deemed a taking and that must be subject to "just compensation."
Assuming for the sake of argument that the physical collocation and unbundled
facilities requirements do result in a taking, we nevertheless find that the
ratemaking methodology we have adopted satisfies the just compensation standard.
Just compensation is normally measured by the fair market value of the property
subject to the taking. n1758 Just compensation is not, however, intended to
permit recovery of monopoly rents. n1759 The just and reasonable rate standard
of TELRIC plus a reasonable allocation of the joint and common costs of
providing network elements that we are adopting attempts to replicate,
[*127]   with respect to bottleneck monopoly elements, the rates that would be
charged in a competitive market, n1760 and, we believe, is entirely consistent
with the just compensation standard. Indeed, a similar rate methodology based on
incremental costs has been found to satisfy the just compensation requirement.
n1761 For these reasons, we conclude that, even if the 1996 Act's physical
collocation and unbundled network facility requirements constitute a taking, a
forward-looking economic cost methodology satisfies the Constitution's just
compensation standard.

   n1758 See, e.g., United States v. Miller, 317 U.S. 369, 374 (1943) (holding
that just compensation can readily be set by ascertaining the property's fair
market value, i.e., "what a willing buyer would pay in cash to a willing
seller").



   n1759 See, e.g., Lord Mfg. Co. v. United States, 84 F. Supp. 748, 755-56
(Ct.Cl. 1949), citing United States v. Cors, 337 U.S. 325, 334 (1949).

   n1760 Compare Policy and Rules Concerning Rates for Dominant Carriers,
Further Notice of Proposed Rulemaking, CC Docket No. 87-313, 3 FCC Rcd 3195,
3200-01 (1988).

   n1761 Metropolitan Transp. Auth. v. Interstate Commerce Commission, 792 F.2d
at 297.  [*128]

   3. Rate Structure Rules

   a. General Rate Structure Rules

   (1) Background

   741. In addition to applying our economic pricing methodology to determine
the rate level of a specific element or interconnection, the state must also
determine the appropriate rate structure. We discuss in this section general
principles for analyzing rate structure questions, such as in what circumstances
charges should be flat-rated or usage sensitive and in what circumstances they
should be recurring or non-recurring. These rate structure rules will apply as
well if a state sets rates based on default proxies discussed in Section VII.C.2
below, where we also discuss the appropriate rate structure for specific network
elements. Network providers incur costs in providing two broad categories of
facilities, dedicated and shared. Dedicated facilities are those that are used
by a single party -- either an end user or an interconnecting network. Shared
facilities are those used by multiple parties. In the NPRM, we proposed that
costs should be recovered in a manner that reflects the way they are incurred.
n1762 We also sought comment on whether we should require states to provide for
recovery of dedicated facility  [*129]   costs on a flat-rated basis, or at a
minimum, require LECs to offer a flat-rate option. n1763

   n1762 NPRM at para. 150.

   n1763 Id. at para. 152.

   (2) Comments

   742. Parties from all sectors of the telecommunications industry agree that
costs should be recovered in a manner that reflects the way they are incurred.
n1764 Lincoln states that using an approach that varies with capacity, without
taking into account the utilization of shared facilities, would not allow small
and mid-sized LECs to recover their total costs, because they lack economies of
scale and scope. n1765 No commenters take issue with that principle or the
principle that the costs of dedicated facilities should be recovered through
flat rates. A wide variety of parties proposed that the Commission adopt such a
rule. n1766 BellSouth, however, opposes rigid rate structure rules, and contends
they could be detrimental if they preclude alternative structures to which
parties are willing to agree. n1767


   n1764 See, e.g., AT&T comments at 67; GSA/DoD comments at 10; Kentucky
Commission comments at 5; Lincoln Tel. comments at 17; Sprint comments at 62;
Texas Public Utility Counsel comments at 36; USTA comments at 57; LDDS comments
at 57; NEXTLINK comments at 30 (generally supporting rate structures that
reflect off-peak costs); Washington Commission comments at 24.  [*130]

   n1765 Lincoln Tel. comments at 17.

   n1766 See, e.g., Florida Commission comments at 31; GSA/DoD comments at 10;
MFS comments at 61-63; Ohio Consumers' Counsel comments at 30;
Telecommunications Resellers Ass'n comments at 42.

   n1767 BellSouth comments at 57-58.

   (3) Discussion

   743. We conclude, as a general rule, that incumbent LECs' rates for
interconnection and unbundled elements must recover costs in a manner that
reflects the way they are incurred. This will conform to the 1996 Act's
requirement that rates be cost-based, ensure requesting carriers have the fight
incentives to construct and use public network facilities efficiently, and
prevent incumbent LECs from inefficiently raising costs in order to deter entry.
We note that this conclusion 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.   [*131]
n1768 We also adopt some more specific rules that follow from this general rule.

   n1768 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

   744. First, we require that the charges for dedicated facilities be
flat-rated, including, but not limited to, charges for unbundled loops,
dedicated transport, interconnection, and collocation. These charges should be
assessed for fixed periods, such as a month. We are requiring flat-rated charges
for dedicated facilities. Usage-based charges for dedicated facilities would
give purchasers of access to network elements an uneconomic incentive to reduce
their traffic volumes. Moreover, purchasers of access to network elements with
low volumes of traffic would pay below-cost prices, and therefore have an
incentive to add lines that they would not add if they had to pay the full cost.
As stated in the NPRM, a fire-rated charge is most efficient for dedicated
facilities, because it ensures that a customer will pay the full cost of the
facility, and no more. It ensures that an entrant will, for example, purchase
the exclusive right to use additional loops only if the entrant believes that
the benefits of the additional loops will exceed its  [*132]   costs. It also
ensures that the entrant will not face an additional (and non-cost-based) usage
charge.

   745. Second, if we apply our general rule that costs should be recovered in a
manner that reflects the way they are incurred, then recurring costs must be
recovered through recurring charges, rather than through a nonrecurring charge.
A recurring cost is one incurred periodically over time. A LEC may not recover
recurring costs such as income taxes, maintenance expenses, and administrative
expenses through a nonrecurring charge because these are costs that are incurred
in connection with the asset over time. For example, we determine that
maintenance expenses relating to the local loop must be recovered through the
recurring loop charge, rather than through a nonrecurring charge imposed upon
the entrant.



   746. We find that recovering a recurring cost through a nonrecurring charge
would be unjust and unreasonable because it is unlikely that incumbent LECs will
be able to calculate properly the present value of recurring costs. To calculate
properly the present value of recurring costs, an incumbent LEC would have to
project accurately the duration, level, and frequency of the recurring  [*133]
costs and estimate properly its overall cost of capital. We find that, in
practice, the present value of the recurring costs cannot be calculated with
sufficient accuracy to warrant up-front recovery of these costs because
incumbent LECs lack sufficient experience with the provision of interconnection
and unbundled rate elements. Without sufficient experience, incumbent LECs are
unable to project the length of time that an average entrant would interconnect
with, or take an unbundled element from, the incumbent LEC, or how expenses
associated with interconnection and unbundled rate elements would change over
time. In contrast, a recurring charge for a recurring cost would ensure that a
customer is only charged for the costs the entrant incurs while that entrant is
taking interconnection service or unbundled rate elements from the incumbent
LEC. Moreover, when costs associated with the interconnection and particular
unbundled rate elements change, the incumbent LEC can make appropriate
adjustments to the charges at the time such cost changes occur.

   747. Accordingly, we find that imposing nonrecurring charges for recurring
costs could pose a barrier to entry because these charges may  [*134]   be
excessive, reflecting costs that may (1) not actually occur; (2) be incurred
later than predicted; (3) not be incurred for as long as predicted; (4) be
incurred at a level that is lower than predicted; (5) be incurred less
frequently than predicted; and (6) be discounted to the present using a cost of
capital that is too low.

   748. Notwithstanding the foregoing, where recurring costs are de minimis, we
will permit incumbent LECs to recover such costs through nonrecurring charges.
We find that recurring costs are de minimis where the costs of administering the
recurring charge would be excessive in relation to the amount of the recurring
costs.

   749. Third, states may, but need not, require incumbent. LECs in an
arbitrated agreement to recover nonrecurring costs, costs that are incurred only
once, through recurring charges over a reasonable period of time. The recovery
of such nonrecurring costs through recurring charges is a common practice for
telecommunications services. Construction of an interconnector's physical
collocation cage is an example of a nonrecurring cost. We find that states may,
where reasonable, require an incumbent LEC to recover construction costs for an
interconneetor's  [*135]   physical collocation cage as a recurring charge over
a reasonable period of time in lieu of a nonrecurring charge. This arrangement
would decrease the size of the entrant's initial capital outlay, thereby
reducing financial barriers to entry. At the same time, any such reasonable
arrangement would ensure that incumbent LECs are fully compensated for their
nonrecurring costs.


   750. We require, however, that state commissions take steps to ensure that
incumbent LECs do not recover nonrecurring costs twice and that nonrecurring
charges are imposed equitably among entrants. A state commission may, for
example, decide to permit incumbent LECs to charge the initial entrants the full
amount of costs incurred for shared facilities for physical collocation service,
even if future entrants may benefit. A state commission may, however, require
subsequent entrants, who take physical collocation service in the same central
office and receive benefits as a result of costs for shared facilities, to pay
the incumbent LEC for their proportionate share of those costs, less
depreciation (if an asset is involved). Under this approach, the state
commission could require the incumbent LEC to provide the  [*136]   initial
entrants pro rata refunds, reflecting the full amount of the charges collected
from the subsequent entrants. Alternatively, a state commission may decide to
permit incumbent LECs to charge initial entrants a proportionate fraction of the
costs incurred, based on a reasonable estimate of the total demand by entrants
for the particular interconnection service or unbundled rate elements.

   751. In addition, state commissions must ensure that nonrecurring charges
imposed by incumbent LECs are equitably allocated among entrants where such
charges are imposed on one entrant for the use of an asset and another entrant
uses the asset after the first entrant abandons the asset. For example, when an
entrant pays a nonrecurring charge for construction of a physical collocation
cage and the entrant discontinues occupying the cage before the end of the
economic life of the cage, a state commission could require that the initial
entrant receive a pro rata refund from the incumbent LEC for the undepreciated
value of the cage in the event that a subsequent entrant takes physical
collocation service and uses the asset. Under this approach, the state
commission could require that the subsequent  [*137]   entrant pay the incumbent
LEC a nonrecurring charge equal to the remaining unamortized value of the cage
and the initial entrant will receive a credit from the incumbent LEC equal to
the unamortized value of the cage at the time the subsequent entrant takes
service and utilizes the cage.

   752. BellSouth's concern that rate structure rules could preclude mutually
agreeable alternative structures is misplaced. The rate structure rules we adopt
here apply only to rates imposed by the states in arbitration among the parties
and to state review of BOC statements of generally available terms. Our rules do
not restrict parties from agreeing to alternative rate structures. On the
contrary, our intent, following the clear pro-negotiation spirit of the 1996
Act, is for parties to use the backdrop of state arbitrations conducted under
our rules, to negotiate more efficient, mutually agreeable arrangements,
subject, of course, to the antitrust laws n1769 and to the 1996 Act's
requirements that voluntarily negotiated agreements not unreasonably
discriminate against third parties. n1770

   n1769 Sherman Antitrust Act, 15 U.S.C. @@ 1 et seq.

   n1770 E.g., 47 U.S.C. @ 252(e)(2)(A)(i).

   b. Additional  [*138]   Rate Structure Rules for Shared Facilities

   (1) Background


   753. In the NPRM, we stated our belief that the costs of shared facilities
should be recovered in a manner that efficiently apportions costs among users
that share the facility. The NPRM noted that, for shared facilities, it may be
efficient to set prices using any of the following: a usage-sensitive charge; a
usage-sensitive charge for peak-time usage and a lower charge for off-peak
usage; or a flat charge for the peak capacity that an interconnector wishes to
pay for and use as though that portion of the facility were dedicated to the
interconnector. n1771
   n1771 NPRM at para. 151.

   (2) Comments

   754. USTA argues that shared facilities are more reasonably priced on a
usage-sensitive basis. n1772 The Florida Commission and Telecommunications
Resellers Association both contend that a variety of charges may be appropriate
for shared facilities. n1773 Telecommunications Resellers Association further
argues that the Commission should "require, where practicable, that LECs offer a
flat-rated option with respect to common facilities and bear the burden of
justifying instances in which they allege that such an option is not   [*139]
workable." n1774 AT&T makes a similar proposal, arguing that rates should
generally be non-usage sensitive except where a usage-based charge is clearly
required. n1775 Lincoln Tel. argues that costs of shared facilities should be
apportioned among users of the shared facility and that a capacity approach that
does not account for utilization of shared facilities would prevent small and
mid-sized LECs from recovering their costs as they lack economies of scale.
n1776

   n1772 USTA comments at 57; see also Lincoln Tel. comments at 17; Sprint
comments at 62; NTIA reply at 33-34.

   n1773 Florida Commission comments at 31; Telecommunications Resellers Ass'n
comments at 42.

   n1774 Telecommunications Resellers Ass'n comments at 42.

   n1775 AT&T comments at 67.

   n1776 See Lincoln Tel. comments at 17.

   (3) Discussion

   755. The costs of shared facilities including, but not limited to, much of
local switching, tandem switching, transmission facilities between the end
office and the tandem switch, and signaling, should be recovered in a manner
that efficiently apportions costs among users. Because the cost of capacity is
determined by the volume of traffic that the facilities are  [*140]   able to
handle during peak load periods, we believe, as a matter of economic theory,
that if usage-sensitive rates are used, then somewhat higher rates should apply
to peak period traffic, with lower rates for non-peak usage. The peak load price
would be designed to recover at least the cost of the incremental network
capacity added to carry peak period traffic. Pricing traffic during peak periods
based on the cost of the incremental capacity needed to handle additional
traffic would be economically efficient because additional traffic would be
placed on the network if and only if the user or interconnecting network is
willing to pay the cost of the incremental network capacity required to handle
this additional traffic. Such pricing would ensure that a call made during the
peak period generates enough revenue to cover the cost of the facilities
expansion it requires, and would thus give carriers an incentive to expand and
develop the network efficiently. In contrast, off-peak traffic imposes
relatively little additional cost because it does not require any incremental
capacity to be added to base plant, and consequently, the price for carrying
off-peak traffic should be lower.



   756.   [*141]   We recognize, however, that there are practical problems
associated with a peak-sensitive pricing system. For example, different parts of
a given provider's network may experience peak traffic volumes at different
times (e.g., business districts may experience their peak period between 10:00
and 11:00 a.m., while suburban areas may have their peak periods between 7:00
and 8:00 p.m.) Moreover, peak periods may change over time. For instance, growth
in Internet usage may create new peak periods in the late evening. Further,
charging different prices for calls made during different parts of the day may
cause some customers to shift their calling to the less expensive time periods,
which could shift the peak or create new peaks. Thus, to design an efficient
peak-sensitive pricing system requires detailed knowledge of both the structure
of costs as well as demand.

   757. We conclude that the practical problems associated with peak-sensitive
pricing make it inappropriate for us to require states to impose such a rate
structure for unbundled local switching or other shared facilities whose costs
vary with capacity. Because we believe that such a structure may be the most
economically efficient,   [*142]   however, we do not prohibit states from
imposing peak-sensitive pricing. We also expect that parties may be able to
negotiate agreements with peak/off, peak differences if the benefits of such
distinctions are sufficiently high. We conclude that states may use either
usage-sensitive rates or flat capacity-based rates for shared facilities, if a
state finds that such rates reasonably reflect the costs imposed by the various
users. States may consider for guidance rate structures developed in competitive
markets for shared facilities. We note that our decisions in this section may
benefit small entity entrants in local exchange and exchange access markets by
minimizing the extent to which purchasers of interconnection and unbundled
access pay rates that diverge from the costs of those facilities and services.
n1777

   n1777 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

   c. Geographic/Class-of-Service Averaging

   (1) Background

   758. In the NPRM, we asked about the appropriate level of aggregation for
rates for interconnection and access to unbundled elements. We noted that
geographic averaging is simple to administer and prevents unreasonable or
unlawful rate differences but,   [*143]   where averaging covers high and low
cost areas, it could distort competitors' decisions whether to lease unbundled
elements or build their own facilities. We sought comment on the geographic
deaveraging of interconnection and unbundled element rates by zone, LATA, or
other area. n1778

   n1778 NPRM at para. 133.

   759. We also inquired about disaggregation by class of service. We questioned
whether business and residential loops, or loops deployed using different
technologies should be charged different rates, and how large a differential
should be allowed. n1779

   n1779 Id.



   (2) Comments

   760. Geographic Deaveraging. Commenters generally agreed that rates for
interconnection and unbundled elements should be geographically deaveraged where
there are significant cost variations. n1780 Many parties assert that there are
large geographic variations in the costs of providing these services and
elements. n1781 Many commenters argue that rates for interconnection and
unbundled elements must be geographically deaveraged in order to meet the
cost-based requirements of sections 251 and 252. n1782 Teleport maintains,
however, that most geographic or class-of-service classifications have arisen
[*144]   from marketing or regulatory considerations and have no basis in cost
causation. n1783 The Ad Hoc Telecommunications Users Committee fears the
"balkanization of [incumbent] LECs' markets" and would only allow geographic
deaveraging where incumbent LECs could demonstrate significant regional
variation in their non-common costs. n1784 It claims that excessive pricing
flexibility would encourage the recovery of common costs to be shifted from
competitive markets to less competitive markets. n1785 Finally, MFS would have
us require geographic averaging to deter anticompetitive, strategic pricing by
incumbent LECs. n1786

   n1780 See, e.g., Connecticut Commission comments at 13-14; N. Economides
comments at 3; Maine Commission, et al. comments at 19. Cf. Colorado Commission
comments at 41; Ohio Consumers' Counsel comments at 27-28 (deaveraging should be
left to states); Pennsylvania Commission comments at 31 (noting industry
movement towards deaveraging); Texas Commission at 24 (Commission should defer
geographic deaveraging and rate rebalancing to universal service proceeding).

   n1781 See, e.g., Cincinnati Bell comments at 27; Lincoln Tel. comments at 14;
Maine Commission, et al. comments at 27-28; Sprint comments at 50-51.  [*145]

   n1782 AT&T comments at 60.

   n1783 Teleport comments at 48.

   n1784 Ad Hoc Telecommunications Users Committee comments at 47.

   n1785 Id.

   n1786 MFS comments at 55-56.


   761. Extent of Deaveraging. Cincinnati Bell, Lincoln Tel., and MECA would
place no limits on the degree of deaveraging that would be permitted. n1787 MCI
and Sprint advocate deaveraging based on the population density in specified
geographic areas or zones. n1788 AT&T also advocates zone density deaveraging
and would have us require at least six zones. n1789 MFS proposes that prices
could be averaged over several possible areas, with state-wide averaging being
the maximum geographic area. To address concerns that widespread averaging may
force low cost areas to subsidize high cost areas, MFS suggests that exchanges
be assigned to a small number of cost bands based on access line density, but
that rates be set at the state-wide average cost of the exchanges assigned to
each zone. n1790 GST generally favors a level of disaggregaton that would
mitigate incumbent LEC administrative expenses, but would require loop
components such as drops to be deaveraged and priced at LRIC. n1791
   n1787 See, e.g., Cincinnati Bell comments at 27; Lincoln Tel. comments at 14;
MECA comments at 46.  [*146]

   n1788 MCI comments at 68; Sprint comments at 50; see also MFS comments at
55-57.

   n1789 AT&T comments at 67.

   n1790 MFS comments at 55-56.

   n1791 GST comments at 30.

   762. Opposition to National Rule. Many state commissions seek flexibility to
determine the degree of deaveraging and argue that this issue should be left to
the states. n1792 Several favor deaveraging wherever the benefits exceed the
administrative costs. n1793 The Connecticut Commission has already allowed SNET
to create four cost categories based on density. n1794 The Michigan Commission
would deaverage rates for interconnection and access to unbundled elements only
where competitive entry warrants such flexibility, subject to a TSLRIC floor
constraint. n1795 Michigan Commission further states that there may also be
non-competitive situations that warrant rate deaveraging, such as when a service
has wide cost variances, when averaging may reduce subscription levels, or when
deaveraging could provide more accurate market signals due to cost variation.
n1796

   n1792 See, e.g., Colorado Commission comments at 41; Connecticut Commission
comments at 13-14; Maine Commission, et al. comments at 19-21; Michigan
Commission comments at 15; Texas Commission comments at 24; see also Ohio
Consumers' Counsel comments at 27-28; California Commission reply at 18.
[*147]

   n1793 See, e.g., Connecticut Commission comments at 13-14; Indiana Commission
comments at 24; Mass. Commission comments at 11 n.5.

   n1794 Connecticut Commission comments at 13-14.

   n1795 Michigan Commission comments at 15-16.

   n1796 Id.


   763. Class-of-Service Deaveraging. In contrast to the general support by
parties for geographic deaveraging, only one party supports class-of-service
deaveraging. n1797 That party, the Ohio Consumers' Counsel, argues that
permitting intercategory restrictions on unbundled elements would be consistent
with intercategory restrictions on resale, such as prohibitions against
reselling residential services to business customers, which are permitted under
the 1996 Act. n1798 Many parties argue that incumbent LECs should not be able to
charge different rates for interconnection or unbundled elements based on the
class of service being provided with the elements or the class of customer
purchasing or using the interconnection or unbundled elements. n1799 According
to most commenters, the 1996 Act's requirement that rates for interconnection
and unbundled elements be cost-based generally precludes class-of-service rate
differences, unless   [*148]   the costs of provision vary significantly across
classes. n1800 Sprint adds that there is no cost justification for rates to
differ when unbundled elements are used for business customers instead of
residential customers. Sprint also argues that requiring different rates for
newer, less-expensive elements would give entrants the incentive to avoid
serving customers connected to older, more-expensive plant, which would leave
incumbent LECs at systematic cost disadvantages. n1801

   n1797 Ohio Consumers' Counsel comments at 27-28.

   n1798 Id.

   n1799 See, e.g., Koch comments at 3; GST comments at 30; Mass. Commission
comments at 11; MFS comments at 56-57; Sprint comments at 50; Teleport comments
at 48.

   n1800 See, e.g., Citizens comments at 18; Mass. Commission comments at 11;
MFS comments at 56-57.

   n1801 Sprint comments at 51.

   (3) Discussion

   764. Geographic Deaveraging. The 1996 Act mandates that rates for
interconnection and unbundled elements be "based on the cost .y . . of providing
the interconnection of network elements." n1802 We agree with most parties that
deaveraged rates more closely reflect the actual costs of providing
interconnection and unbundled elements.   [*149]   Thus, we conclude that rates
for interconnection and unbundled elements must be geographically deaveraged.

   n1802 47 U.S.C. @ 252(d)(1)(a)(i).

   765. The record reflects that at least two states have implemented
geographically-deaveraged rate zones. n1803 These rate zone pricing systems have
generally included a minimum of three zones. In the Expanded Interconnection
proceeding, the Commission also permitted LECs to implement a three zone
structure. n1804 We conclude that three zones are presumptively sufficient to
reflect geographic cost differences in setting rates for interconnection and
unbundled elements, and that states may, but need not, use these existing
density-related rate zones. Where such systems are not in existence, states
shall create a minimum of three cost-related rate zones to implement deaveraged
rates for interconnection and unbundled elements. A state may establish more
than three zones where cost differences in geographic regions are such that it
finds that additional zones are needed to adequately reflect the costs of
interconnection and access to unbundled elements.

   n1803 Connecticut Commission comments at 13; Illinois Commission comments at
Attachment C (Illinois Commerce Commission Order), p.54, 60-61.  [*150]

   n1804 Expanded Interconnection with Local Telephone Company Facilities and
Amendment of the Part 69 Allocation of General Support Facility Costs, CC Docket
Nos. 91-141 and 92-222, Report and Order and Notice of Proposed Rulemaking, 7
FCC Rcd 7369, 7454-57 (1992) (Expanded Interconnection Order); Second Report and
Order and Third Notice of Proposed Rulemaking, 8 FCC Rcd 7374, 7426-29 (1993).
LEC central offices in areas with the highest traffic densities were assigned to
Zone 1; offices in areas with intermediate degrees of density were assigned to
Zone 2; and offices in areas with the lowest density were assigned to Zone 3.



   766. Class-of-Service Deaveraging. The record leads us to the opposite
conclusion for class-of-service deaveraging. Under the 1996 Act, wholesale rates
for resold services will be based on retail rates less avoided costs. Rates for
interconnection and access to unbundled elements, however, are to be based on
costs. We conclude that the pricing standard for interconnection and unbundled
elements prohibits deaveraging that is not cost based. Interconnection and
unbundled elements are intermediate services provided by incumbent LECs to other
telecommunications  [*151]   carriers, and there is no evidence that the cost of
providing these intermediate services varies with the class of service the
telecommunications carrier is providing to its end-user customers. We conclude
that states may not impose class-of-service deaveraging on rates for
interconnection and unbundled elements. We disagree with the Ohio Consumers'
Counsel's position that the 1996 Act's explicit permission of class-of-service
deaveraging of resold services implies that class-of-service deaveraging should
be permitted for interconnection and unbundled elements. Finally, we note that
these decisions concerning averaging may be expected to lead to increased
competition and a more efficient allocation of resources, which should benefit
the entire industry, including small entities and small incumbent LECs. n1805

   n1805 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

C. Default Proxy Ceilings and Ranges

   767. As previously discussed, we strongly encourage state commissions, as a
general rule, to set arbitrated rates for interconnection and access to
unbundled network elements pursuant to the forward-looking, economic cost
pricing methodology we adopt in this Order. Such   [*152]   rates would
approximate levels charged in a competitive market, would be economically
efficient, and would be based on the forward-looking, economic cost of providing
interconnection and unbundled elements. We recognize, however, that, in some
cases, it may not be possible for carriers to prepare, or the state commission
to review, economic cost studies within the statutory time frame for arbitration
and thus here first address situations in which a state has not approved a cost
study. States that do not complete their review of a forward-looking economic
cost study within the statutory time periods but must render pricing decisions,
will be able to establish interim arbitrated rates based on the proxies we
provide in this Order. A proxy approach might provide a faster, administratively
simpler, and less costly approach to establishing prices on an interim basis
than a detailed forward-looking cost study.

   768. The default proxies we establish will, in most cases, serve as
presumptive ceilings. States may set prices below those ceilings if the record
before them supports a lower price. States should provide a reasoned basis for
selecting a particular default price. In one case, for  [*153]   local
switching, the default proxy is a range within which a state may set prices.


   769. States that set prices based upon the default proxies must also require
the parties to update the prices in the interconnection agreement on a
going-forward basis, either after the state conducts or approves an economic
study according to the cost-based pricing methodology or pursuant to any
revision of the default proxy. We believe generic economic cost models, n1806 in
principle, best comport with the preferred economic cost approach described
previously, and we intend to examine further such models by the fast quarter of
1997 to determine whether any of those models, with any appropriate
modifications, could serve as better default proxies. Any updated price would
take effect beginning at the time of the completed and approved study or the
application of the revised default proxy.

   n1806 See Section VII.C.3. infra.

   770. Second, if a state has approved or conducted an economic cost study,
prior to this Order, that complies with the methodology we adopt in this Order,
the state may continue to apply the resulting rate even when not consistent with
our default proxies. There must, however,   [*154]   be a factual record,
including the cost study, sufficient for purposes of review after notice and
opportunity for the affected parties to participate.

   771. Finally, while we provide for the use by states of default proxies, we
recognize that certain states that are unable to utilize an economic cost study
may wish to obtain the benefits of setting rates pursuant to such a study for
its residents. The Commission will therefore entertain requests by states to
review an economic cost study, to assist the state in conducting or reviewing
such a study, or to conduct such a study.

   1. Use of Proxies Generally

   a. Background

   772. In the NPRM, we discussed the possibility of setting certain outside
limits for interconnection and unbundled element rates, in particular, by the
use of proxies. We invited parties to comment on whether the use of certain
proxies to set outer boundaries on the prices for interconnection and unbundled
elements would be consistent with the pricing principles of the 1996 Act.
Specifically, in the NPRM, we asked parties to comment on the benefits of
various types of proxies: (1) generic cost studies, such as the Benchmark Cost
Model and the Hatfield models; n1807  [*155]   (2) some measure of
nationally-averaged cost data; n1808 (3) rates in existing interconnection and
unbundling arrangements between incumbent LECs and other providers of local
service, such as neighboring incumbent LECs, CMRS providers, or other entrants
in the same service area; n1809 (4) a subset of the incumbent LECs' existing
interstate access rates, charged for interconnection with IXCs and other access
customers, or an intrastate equivalent; n1810 (5) use of the interstate prices
established in the ONA proceeding for unbundled features and functions of the
local switch as ceilings for the same unbundled elements under section 251;
n1811 and (6) any other administratively simple methods for establishing a
ceiling for interconnection and unbundled network element rates. n1812 As a
counterpart to ceilings, we also sought comment on whether it would be necessary
or appropriate for us to establish floors for interconnection and unbundled
element prices. n1813

   n1807 NPRM at para. 137; see infra, Section VII.C.3, discussing generic cost
models.

   n1808 NPRM at para. 137.

   n1809 Id. at para. 138.

   n1810 Id. at paras. 139-140.



   n1811 Id. at para. 140.

   n1812 Id. at para. 141.  [*156]

   n1813 Id. at para. 143.

   b. Comments

   773. Proxies Generally. A number of parties offer general support for the use
of cost proxies to establish upper limits on the rates that incumbent LECs may
charge for interconnection and unbundled elements. n1814 Ad Hoc
Telecommunications Users Committee cautions, however, that using a proxy
approach does not eliminate the need for detailed analysis of the cost
methodologies and cost inputs upon which the proxy is based. n1815 In addition,
USTA contends that the Commission should establish a presumptive framework using
targets based on pricing proxies, from which the states would be permitted to
depart based on individual circumstances. n1816

   n1814 See, e.g., GSA/DoD comments at 8; Cox comments at 31, reply at 30;
WinStar comments at 31; NEXTLINK comments at 27-28; Texas Public Utility Counsel
Comments at 28-33; NCTA comments at Attachment A (Declaration of Bruce M. Owen),
pp.5-6, reply at 18-19; see also USTA comments at 50 ("may be a feasible way to
establish presumptively valid rates for some unbundled elements").

   n1815 Ad Hoc Telecommunications Users Committee comments at 48-49.

   n1816 USTA reply at 19, 28; see also Washington Commission comments at 27.
[*157]

   774. Incumbent LECs and AT&T generally oppose the use of proxies. n1817 They
argue that a national proxy methodology for all network elements is
inappropriate because it would not reflect cost-based rates, n1818 may restrict
competitive entry, n1819 does not allow for variations among the states, n1820
and is inconsistent with the 1996 Act's mandate of economic costing. n1821
Several commenters contend that the use of proxies could harm small and
mid-sized incumbent LECs if such proxies are developed from larger geographic
and demographic scales. n1822 In addition, Ameritech opposes the use of proxies
for those states that have already adopted cost methodologies and urges the
Commission to limit application of such proxies to states that have not yet
adopted appropriate cost and pricing methodologies. n1823

   n1817 See, e.g., AT&T comments at $ 2-5B; Bell Atlantic comments at 39;
Cincinnati Bell comments at 27; Frontier comments at 22-23; LDDS comments at 65
n.66; Lincoln Tel. comments at 15-16.

   n1818 See, e.g., ALTS comments at 37; AT&T comments at 53; NYNEX comments at
53; Lincoln Tel. comments at 15-16; Texas Statewide Telephone Cooperative
comments at 14; Rural Tel. Coalition comments at 22; Washington Independent Tel.
Ass'n comments at 6.  [*158]

   n1819 E.g., Cincinnati Bell comments at 28; AT&T comments at 53.

   n1820 See, e.g., Bell Atlantic comments at 39; Rural Tel. Coalition comments
at 22; Wyoming Commission comments at 31; Alaska Commission comments at 2-3.



   n1821 See, e.g., ALTS comments at 35; Time Warner comments at 54-55;
Washington Independent Tel. Ass'n comments at 6-7; Ohio Commission comments at
50.

   n1822 See, e.g., Cincinnati Bell comments t 25; Colorado Independent Tel.
Ass'n comments at 4; Illinois Ind. Ass'n comments at 5; Lincoln Tel. comments at
17; Matanuska Tel. comments at 4; Rural Tel. Coalition comments at 22, 28-29;
SBA comments at 16; TDS comments at 22.

   n1823 Ameritech comments at 61.

   775. Floors and Ceilings. Several commenters oppose adoption of a federal
floor and ceiling for the rates of interconnection and access to unbundled
elements. n1824 They argue generally that such an approach is inferior to a
prescription of a specific methodology because it results in rates that are not
cost-based and therefore inconsistent with the statute, provides an incentive to
incumbent LECs to price inefficiently at the maximum, and removes incentives for
upgrading network technology.   [*159]   n1825 Moreover, any such price ceiling
would have to be set as high as the reasonable price for the highest cost
company or be challenged as confiscatory when higher cost LECs are unable to
recover their costs. n1826 In addition, the Texas Public Utility Counsel notes
that floors impair the ability of competition to reveal how low. costs really
are. n1827

   n1824 See, e.g., Frontier comments at 22; Lincoln Tel. comments at 14-15;
MECA comments at 47; Pennsylvania Commission comments at 31; Telecommunications
Resellers Ass'n comments at 41.

   n1825 See, e.g., NYNEX comments at 57; Frontier comments at 22-23; Lincoln
Tel. comments at 14-15; AT&T comments at 52-53; TDS comments at 22.

   n1826 Oregon Commission comments at 29-30; see also GVNW comments at 38-39.

   n1827 Texas Public Utility Counsel comments at 33.


   776. Many parties agree, however, that if the Commission establishes pricing
guidelines it should use an "outer bounds" pricing approach or require pricing
within a zone of reasonableness. n1828 Others support an "outer bounds" if the
Commission ensures that states will have sufficient leeway to accommodate
state-specific situations, n1829 and the range of reasonableness  [*160]   is
not so circumscribed as to reduce the range to the equivalent of a price point.
n1830 They argue that establishing separate floors and ceilings enables the
Commission to set absolute boundaries that frame the debate with the incumbent
LEC concerning relevant costs and prices during negotiations and ultimately
arbitration, while giving states flexibility to address state-specific costing
issues. n1831 Parties assert that calculation of a perfectly correct, single
price is impossible and that cost boundaries allow states to choose an
acceptable pricing result with a range of reasonable rates. n1832 Several
parties agree that the Commission should establish a presumptive rate ceiling,
and that rates exceeding the ceiling should be presumed unlawful. n1833 USTA
contends that, if the Commission adopts rate ceilings, such ceilings should
indicate levels above which rates must be further justified. n1834 Ameritech
maintains that floors should be used only as a benchmark below which rates may
not be set in order to guard against cross-subsidization and predatory pricing.
n1835
   n1828 See, e.g., Ad Hoc Telecommunications Users Committee comments at 48;
BellSouth comments at 55; Cox comments at 24; GSA/DoD comments at 8; NEXTLINK
comments at 27-28; SBC comments at 93; USTA comments at 38; WinStar comments at
31; NCTA reply at 18.  [*161]

   n1829 See, e.g., Kentucky Commission comments at 5; Ohio Consumers' Counsel
comments at 29; Puerto Rico Tel. comments at 10-11; Washington Commission
comments at 26.

   n1830 See, e.g., BellSouth comments at 55.

   n1831 See, e.g., GSA/DoD comments at 8; Cox comments at 24, reply at 30-31;
NEXTLINK comments at 27-28.

   n1832 See, e.g., Rural Tel. Coalition comments at 30.

   n1833 See, e.g., ACSI comments at 56; Bell Atlantic comments at 39-40;
Cincinnati Bell. comments at 27, 30; MCI comments at 60; PacTel comments at
73-74; Texas Public Utility Counsel comments at 28-29.

   n1834 USTA comments at 50.

   n1835 Ameritech comments at 73; see also GSA/DoD comments at 8; Ohio
Consumers' Counsel comments at 28; TDS comments at 20.

   777. Generic Cost Models. Several generic forward-looking cost models were
introduced into the record. These are discussed in Section VII.C.3. below.

   778. Nationally-Averaged Costs. Although a few commenters support the use of
nationally-averaged costs as a proxy to establish the rates for interconnection
and unbundled network elements, n1836 many more parties oppose the use of such
nationally-averaged cost data. n1837 These parties argue  [*162]   that
nationally-averaged data ignore geographically divergent factors and the
interests of small or rural LECs, do not account for variance of cost between
incumbent LECs, and do not reflect the true cost of the service. n1838 No
nationally-averaged cost studies were introduced into the record.

   n1836 See, e.g., MECA comments at 47; PacTel comments at 74; Sprint comments
at 55; see also ACSI comments at 56.

   n1837 See, e.g., Ad Hoc Telecommunications Users Committee comments at 49-50;
Bay Springs, et al. comments at 17; Cincinnati Bell comments at 28; Colorado
Independent. Tel. Ass'n comments at 4; Florida Commission comments at 29;
Illinois Independent Tel. Ass'n comments at 5-6; Lincoln Tel. comments at 15-16;
Telecommunications Resellers Ass'n comments at 41.

   n1838 See, e.g., Ad Hoc Telecommunications Users Committee comments at 49;
Bay Springs, et al. comments at 17; Cincinnati Bell comments at 28; GVNW
comments at 31-38.


   779. Existing Interconnection Agreements. Generally, commenters oppose the
use of rates in existing interconnection agreements as a proxy-based ceiling for
interconnection and unbundled element rates. n1839 These parties argue that,
because the   [*163]   agreements are the subject of the negotiation between two
carriers with their own particular characteristics and needs, such agreements
are likely to be inconsistent and not cost-based, may not be based on the
pricing standards codified at 252(d), and the services covered by these
agreements may not be those that entrants need to purchase. n1840 A few parties
express qualified support for a proxy based on the rates in existing
interconnection agreements between incumbent LECs, arguing that such rates have
already been scrutinized and determined to be just and reasonable. n1841 WinStar
cautions that the Commission should not use the rates contained in the existing
interconnection agreements between incumbent LECs and CMRS providers or other
new entrants as a proxy ceiling because they were negotiated by parties with
unequal bargaining power. n1842

   n1839 See, e.g., ACSI comments at 58; Ad Hoc Telecommunications Users
comments at 52; Cincinnati Bell comments at 28-29; Colorado Commission comments
at 43; Florida Commission comments at 30; MCI comments at 70; Telecommunications
Resellers Ass'n comments at 41.

   n1840 See, e.g., Ad Hoc Telecommunications Users Committee comments at 52;
Florida Commission comments at 30; Telecommunications Resellers Ass'n comments
at 41; Time Warner comments at 55.  [*164]

   n1841 See, e.g., Bell Atlantic comments at 39-40; Ohio Consumers' Counsel
comments at 28-29; PacTel reply at 34-35; Pennsylvania Commission comments at
31; Texas Commission comments at 24-25; WinStar comments at 32.

   n1842 WinStar comments at 34; see also Telecommunications Resellers Ass'n
comments at 41; ACSI comments at 58.

   780. Interstate Access. A number of parties support the use of a proxy based
on existing interstate access charges, claiming that it is easy to apply, based
on cost, and would be self-correcting as the access reform and universal service
proceedings remove subsidies from access rates. n1843 ALLTEL further maintains
that if access charges are used, there should be no requirement for small and
mid-sized LECs to produce cost studies that could hamper their interconnection
negotiations. n1844 USTA further argues that such proxies are important to all
LECs, but are especially important for rural, small, and mid-sized LECs subject
to the two percent waiver process, who should not be subjected to the burden of
producing expensive and time-consuming cost studies. n1845 Several parties note
that some access charges may need to be adjusted or converted to reflect
[*165]   the characteristics of particular unbundled service offerings. n1846
Others oppose the development of a proxy-based ceiling derived from existing
interstate access rates, because access charges are based on historical, rather
than economic, costs, and contain inordinate mounts of contribution. n1847 These
commenters note that setting rates for other elements that could not be derived
from access rates would involve application of different proxies, n1848 and the
intrastate and interstate rates associated with common lines are applied in
different ways to different categories and classes of customers. n1849 NYNEX
argues access charges were designed for a different purpose than interconnection
and unbundled elements and therefore would be inappropriate proxies. n1850

   n1843 See, e.g., ALLTEL comments at 10-11; Bell Atlantic comments at 39-40,
56; BellSouth comments at 56; Cincinnati Bell comments at 29; SBC comments at
94; USTA comments at 54, reply at 28.

   n1844 ALLTEL comments at 11.



   n1845 USTA reply at 27-28.

   n1846 See, e.g., Cincinnati Bell at 30; SBC comments at 95; USTA comments at
54.

   n1847 See, e.g., ACSI comments at 58; Ad Hoc Telecommunications Users
Committee comments at 52-53; Colorado Commission comments at 43; Frontier
comments at 23; Lincoln Tel. comments at 15-16; MCI comments at 70; MFS comments
at 57 n.66.  [*166]

   n1848 See, e.g., Ad Hoc Telecommunications Users Committee comments at 52-53.

   n1849 See, e.g., NYNEX comments at 59-60.

   n1850 NYNEX comments at 58-59.

   781. In addition, several parties assert that a proxy based on access charges
should include all or part of the CCLC or TIC, because otherwise it would be
impossible to determine whether an appropriate mount of joint and common costs
would be recovered, and IXCs would be able to reconstruct access through
unbundled elements priced less than access. n1851 GVNW argues that the TIC is
particularly important for small LECs that are not allowed to charge a rate that
more accurately reflects their tandem switched transport costs. n1852 On the
other hand, several commenters argue that the CCLC and TIC should be excluded,
n1853 and WinStar further maintains that, even without those elements, access
charge rates would still be too high to serve as a proxy ceiling. n1854

   n1851 See, e.g., Cincinnati Bell comments at 29; NYNEX comments at 59; Texas
Commission comments at 25; USTA comments at 51-53.

   n1852 GVNW comments at 39.

   n1853 See, e.g., Sprint comments at 58; Texas Public Utility Counsel comments
at 30-32; WinStar comments at 36-37.  [*167]

   n1854 WinStar comments at 36-37.

   c. Discussion

   782. We adopt, in the section below, default proxies for particular network
elements. We believe that these default proxies generally will result in
reasonable price ceilings or price ranges and, for administrative and practical
reasons, will be beneficial to the states in conducting initial rate
arbitrations, especially in the time period prior to completion of a cost study.
The proxies we adopt are designed to approximate prices that will enable
competitors to enter the local exchange market swiftly and efficiently and will
constrain the incumbent LECs' ability to preclude efficient entry by
manipulating the allocation of common costs among services and elements. States
that utilize the default proxies we establish to set prices in an arbitration
should revise those prices on a going-forward basis when they are able to
utilize the preferred economic costing methodology we describe in Section
VII.B.2.a. above, or if we subsequently adopt new proxies. n1855

   n1855 See infra, Section VII.C.3., discussing generic cost models.



   783. We have considered the economic impact of the adoption of default proxy
ceilings and ranges on small  [*168]   entities, including new entrants and
small incumbent LECs. n1856 The adoption of proxies for interim arbitrated rates
should minimize regulatory burdens on the parties to arbitration, including
small entities seeking to enter the local exchange markets and small incumbent
LECs, by permitting states to implement the 1996 Act more quickly and
facilitating competition on a reasonable and efficient basis by all firms in the
industry. We therefore believe that the adoption of default proxy ranges and
ceilings advances the pro-competitive goals of the 1996 Act. 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. n1857

   n1856 See Regulatory Flexibility Act, 5 U.S.C. @@ 601 et seq.

   n1857 47 U.S.C. @ 251(f).

   784. The proxies that we establish represent the price ceiling or price
ranges for the particular element on an averaged basis. In Section VII.B.3.c.
above, we required that rates be set on a geographically-deaveraged basis.
[*169]   Consequently, states utilizing the proxies shall set rates such that
the average rate for the particular element in a study area does not exceed the
applicable proxy ceiling or lie outside the proxy range.

   785. We reject the use of rates in interconnection agreements that predate
the 1996 Act as a proxy-based ceiling for interconnection and unbundled element
rates. n1858 These existing interconnection agreements were not reached in a
competitive market environment. Further, such agreements may reflect the
divergent bargaining power of the parties to the agreement, various public
policy initiatives to advance rural telephone service, or non-monetary quid pro
quos often found in voluntarily negotiated business arrangements that may be
difficult to quantify. There is little basis for us to conclude that rates in
these interconnection agreements reflect the forward-looking, incremental cost
of interconnection and unbundled network elements. Prices in agreements reached
since the 1996 Act are more likely than prior agreements to provide useful
information about forward-looking costs, which together with other information
may be useful in establishing proxies.

   n1858 See discussion supra, Section III.C., concerning the applicability of
section 252 to preexisting agreements.  [*170]

   786. In the NPRM, we also raised the issue of using some measure of
nationally-averaged cost data as a proxy. n1859 No such study has been submitted
into the record in this proceeding.

   n1859 NPRM at para. 137.

   2. Proxies for Specific Elements

   a. Overview


   787. Although we encourage states to use an economic cost methodology to set
rates for interconnection, unbundled network elements, and collocation, we will
permit states unable to analyze an economic costing study within the statutory
time constraints to use default proxies in setting and reviewing rates. We set
forth below the default proxies for specific network elements. These proxies are
interim only. They will apply only until a state sets rates in arbitrations on
the basis of an economic cost study, or until we promulgate new proxies based on
economic cost models. n1860 We also set forth below the rate structure rules
that apply to each of network elements. These rate structure requirements are
applicable regardless of whether a state uses an economic cost study or the
proxy approach to set rate levels.

   n1860 See infra, Section VII.C.3., discussing generic cost models.

   b. Discussion

   (1) Loops

   (a) Comments   [*171]

   788. A number of commenters assert that unbundled loops, in particular, are
dedicated facilities, and therefore should be priced on a flat-rated basis.
n1861 Sprint suggests that prices for unbundled loops not depend on minutes of
use, but rather distance. n1862 MFS urges the Commission to preempt a Texas
statute that, it contends, requires incumbent LECs to price unbundled loops on a
usage-sensitive basis. n1863

   n1861 See, e.g., CompTel comments at 36; Florida Commission comments at 31;
MFS comments at 62; see also AT&T comments at 67; GSA/DoD comments at 10.

   n1862 Sprint comments at 62.

   n1863 MFS comments at 62.

   (b) Discussion

   789. Most loop costs are associated with a single customer. n1864 Outside
plant between a customer's premises and ports on incumbent LEC switches is
typically either physically separate for each individual customer, or has costs
that can easily be apportioned among users. We therefore conclude that costs
associated with unbundled loops should be recovered on a flat-rated basis.
Usage-based rates for an unbundled loop would most likely translate into
usage-based rates for new entrants' retail local customers. A retail usage-based
rate would   [*172]   distort incentives for efficient use. Customers that had
to pay a usage charge would have an incentive not to use the network in
situations where the benefit of using the network exceeds the true cost of using
the network. Usage-based loop prices would put an entrant at an artificial cost
disadvantage when competing for high-volume customers. n1865

   n1864 See MTS and WATS Market Structure, CC Docket No. 78-72, Phase I, Third
Report and Order, 93 FCC 2d 241, 291-297 (1983).


   n1865 We note that MFS has filed a separate petition asking the Commission to
preempt certain provisions of the Texas statute, which it contends requires
incumbent LECs to sell unbundled local loops on a usage-sensitive basis. See
Public Notice, Petition for Preemption of Local Entry Barriers Pursuant to
Section 253, 11 FCC Rcd 6578 (Com. Car. Bur. 1996) (MFS Texas Petition). We will
rule specifically on the Texas statute when we consider the MFS Texas
Petition.

   790. In general, we believe that states should use a TELRIC methodology to
establish geographically deaveraged, flat-rate charges for access to unbundled
loops. As discussed above, however, we recognize that, in some cases, it may not
be possible  [*173]   for carriers to prepare, or for state commissions to
review, economic cost studies within the statutory time frame for arbitration
proceedings. Because reviewing and approving such cost studies takes time and
because many states have not yet begun, or have only recently begun, to develop
and examine such studies, it is critical for the near-term development of local
competition to have proxies that provide an approximation of forward-looking
economic costs and can be used by states almost immediately. These proxies would
be used by a state commission until it is able either to complete a cost study
or to evaluate and adopt the results of a study or studies submitted in the
record. In an NPRM to be issued shortly, we will investigate more fully various
long-run incremental cost models in the record with an eye to developing a model
that can be used to generate proxies for the forward looking economic costs of
network elements. Until such time as we can develop such a model, we have
developed the following default proxy ceilings that state commissions that have
not completed forward looking economic cost studies may use in the interim as an
approximation to the forward looking cost   [*174]   of the local loop.

   791. State commissions may use this proxy to derive a maximum (or ceiling)
loop rate for each incumbent LEC operating within their state, and may establish
actual unbundled loop rates at any level less than or equal to this maximum rate
in specific arbitrations or other proceedings. Of course, we are encouraging
states to have economic studies completed wherever feasible. Moreover, states
will have to replace this proxy ceiling with the results of their own forward
looking economic cost study or the results produced by a generic economic cost
model that the Commission has approved. n1866

   n1866 See infra, Section VII.C.3., discussing generic cost models.

   792. We are adopting a proxy ceiling based on two cost models and rates for
unbundled loops allowed by six states that had available to them the results of
forward-looking economic cost studies at the time they considered either interim
or permanent rates for the unbundled loop element. These states are Colorado,
Connecticut, Florida, Illinois, Michigan, and Oregon. Each of these states has
used a standard that appears to be reasonably close to the forward-looking
economic cost methodology that we require to  [*175]   be used, although
possibly not consistent in every detail with our TELRIC methodology. n1867
Generally, these states appear to have included an allocation of forward-looking
common costs in their unbundled loop prices. The individual state studies
resulted in the following average rates for unbundled local loops: Colorado, $
18; Connecticut, $ 12.95; Florida, $ 17.28; Illinois, $ 10.93; Michigan, $
10.03; and Oregon, $ 12.45, computed as set forth below.


   n1867 See In re: US West Communications, Inc. Filing of Advice Letter No.
2610 In Compliance with Commission Decision No. C96-521 Adopting Emergency Rules
(Tariff), Docket No. 96S-233T, Decision No. C96-655 (Colorado Commission, June
21, 1996) ["Colorado Decision"] at 58-64 (interim unbundled loop prices set
after review of TSLRIC cost studies); Re Southern New England Telephone Company,
Order No. 95-06-17, 1995 WL 803837 (Conn. D.P.U.C., December 20, 1995)
["Connecticut Decision"] at 9-10, 72 (same); In re: application of City Signal,
Inc., for an order establishing and approving interconnection arrangements
with Ameritech Michigan, Case No. U-10647 (Michigan Commission, February 23,
1995) ["Michigan Decision"] at 32, 56-57 (setting interim unbundled loop rates
based on estimated TSLRIC costs); In Re: Resolution of petition(s) to establish
nondiscriminatory rates, terms and conditions for resale involving local
exchange companies and alternative local exchange companies and alternative
local exchanges companies pursuant to Section 364.161, Florida Statutes, Docket
No. 950984-TP, Order No. PSC-96-0444-FOF-TP, (Florida Commission, March 29,
1996) ["Florida Decision I"] at 16 (interim unbundled loop prices set with
reference to BellSouth cost studies); In Re: Resolution of petition(s) to
establish nondiscriminatory rates, terms and conditions for resale involving
local exchange companies and alternative local exchange companies and
alternative local exchanges companies pursuant to Section 364.161, Florida
Statutes, Docket No. 950981-TP, Order No. PSC-96-0811-FOF-TP (Florida
Commission, June 24, 1996) ["Florida Decision II"] at 25-26 (setting rates after
review of GTE and United/Centel cost studies); In re: Investigation into the
Cost of Providing Telecommunications Services, Order No. 96-188, (Oregon
Commission, July 19, 1996) ["Oregon Decision"] at 78 n.61 (interim unbundled
loop prices generally based on LRIC estimates plus applicable group related
costs, and an additional contribution for recovery of joint and common costs);
Illinois Bell Telephone Company Proposed introduction of a trial of Ameritech's
Customers First Plan in Illinois, Docket Nos. 94-0096/94-0117/94-0146/94-0301
(Illinois Commission, April 7, 1995) ["Customers First Order"] at 54, 61 (rates
set with reference to Ameritech's LRSIC studies).  [*176]

   793. The Colorado Commission set an interim rate of $ 18 per month for
unbundled loops terminated at the main distribution frame of the LEC switch.
n1868 The Connecticut Commission ruled that SNET must provide the following
interim unbundled loop prices varying by four zones: metro $ 10.18; urban $
11.33; suburban $ 15.33; and rural $ 14.97. n1869 In the absence of further
information about customer density or average loop length by zone, we used a
simple average equal to $ 12.95. The Florida Commission set an interim rate for
2-wire loops at $ 17.00 per month for BellSouth, $ 15.00 for United/Centel, and
$ 20.00 for GTE. n1870 Using weights equal to the number of loops served by each
company in 1994 as reported in the Monitoring Report, n1871 we computed a
weighted average price equal to $ 17.28. Pursuant to its Customers First Order,
the Illinois Commerce Commission approved tariffs establishing business rates
equal to $ 7.08, $ 10.92, and $ 14.45, and residential rates equal to $ 4.59, $
8.67, and $ 12.14 in three density zones. n1872 Based on data from Table 2.5,
page 20 of the Common Carrier Statistics, 1995 Preliminary, we found a 36
percent - 64 percent business residential  [*177]   split. Using Illinois
Commission data for number of households in each density zone (996,750 in zone
A; 2,788,759 in zone B; 4,594,567 in zone C), we computed an average loop cost
of $ 10.93. The Michigan Commission approved transitional rates of $ 8.00 per
loop for business and $ 11 per loop for residence. n1873 Based on Common Carrier
Statistics, 1995 Preliminary data, we computed a 32 percent - 68 percent
business-residential split in Michigan, which leads to an average rate of $
10.03. The Oregon Commission set the rate for a "basic 2-wire loop set" at $
11.95 plus $ 0.50 for a network access channel connection, for a total price of
$ 12.45. n1874

   n1868 Colorado Decision at 66.

   n1869 Connecticut Decision at 74.



   n1870 Florida Decision I at 19; Florida Decision II at 25-26.

   n1871 Monitoring Report, CC Docket No. 87-339, May 1996 (listing the
following number of loops by company: GTE, 1,909,172; United/Centel, 1,627,314;
BellSouth, 5,328,280).

   n1872 See Ameritech Tariff, Ill. C.C. No. 20, Part 19, Section 1, issued
October 23, 1995.

   n1873 Michigan Decision at 94.

   n1874 Oregon Decision at Appendix C, p.1.


   794. In order to set a proxy ceiling for   [*178]   unbundled loop elements
we make use of the two cost models for which nationwide data are available and
upon which parties have had the opportunity to comment in this proceeding. These
models are the Benchmark Cost Model (BCM) n1875 and the Hatfield 2.2. n1876
Based on our current information, we believe that both these models are based on
detailed engineering and demographic assumptions that vary among states, and
that the outputs of these models represent sufficiently reasonable predictions
of relative cost differences among states to be used as set forth below to set a
proxy ceiling on unbundled loop prices for each state. We do not believe,
however, that these model outputs by themselves necessarily represent accurate
estimates of the absolute magnitude of loop costs. As we discuss below, further
analysis is necessary in order to evaluate fully the procedures and input
assumptions that the models use in order to derive cost estimates. Furthermore,
in the case of BCM, model outputs include costs in addition to the cost of the
local loop. In order to correct for these considerations, we have developed a
hybrid cost proxy in the following manner. First, we have applied a scaling
factor  [*179]   to the cost estimates of each model. This scaling is based on
the actual rates computed for unbundled loop elements in the six states referred
to above. Specifically we have multiplied the cost estimate produced by each
model in each state by a factor equal to the unweighted average of rates adopted
by state commissions in the six states, divided by the unweighted average of the
model cost estimates for the same six states. Our hybrid cost proxy is computed
as the simple average of the scaled cost estimates for the two models in each of
the 48 contiguous states and the District of Columbia. Neither BCM nor Hatfield
2.2 provide cost estimates for Alaska and only the BCM provides an estimate for
Hawaii. Our default loop cost proxies for Hawaii and Puerto Rico are based on
the default loop cost proxies of the states that most closely approximate them
in population density per square mile. n1877 We are not setting default loop
cost proxies in this Order for Alaska or for any of the remaining non-contiguous
areas subject to the 1996 Act requirement that incumbent LECs offer unbundled
loop elements. We are not establishing default loop cost proxies for these areas
because we are unsure   [*180]   that comparisons of the population densities of
the continental states and of Alaska and other non-contiguous areas subject to
the 1996 Act fully capture differences in loop costs. Regulatory authorities in
those areas may seek assistance from this Commission should default loop cost
proxies be needed before they have completed their investigations of the
forward-looking costs of providing unbundled loop elements. Since our intention
is to establish a ceiling for unbundled loop rates, we believe that it is
necessary to take account of the variation in the data that we have used for
scaling. While the six states that we considered appear to have based their
rates on forward-looking economic cost pricing principles, the actual rates that
they approved appear to reflect other factors as well. Furthermore, because
only a small number of states have conducted such studies, some upward
adjustment is warranted as a safety margin to ensure that the ceiling captures
the variation in forward-looking economic costing prices on a state-by-state
basis. We have therefore chosen to adjust the hybrid cost estimates upward by
five percent for each state. A table listing the proxy ceilings on a statewide
[*181]   average basis is contained in Appendix D.

   n1875 Benchmark Cost Model: A Joint Submission by MCI Communications, Inc.,
NYNEX Corporation, Sprint Corporation, U S West, Inc. (December 1995), submitted
by MCI Communications, Inc., NYNEX Corp., Sprint/United Management Corp., U S
West, Inc. on July 24, 1996 (BCM). For a more detailed discussion of the BCM,
see infra, Section VII.C.3.

   n1876 Hatfield Model, Version 2.2 Release 1, (Hatfield Associates, Inc.,
March 1996), submitted by AT&T and MCI on May 16, 1996 (Hatfield 2.2); see also
AT&T reply at Appendix D (Update of the Hatfield Model Version 2.2, Release 1).
See infra, Section VII.C.3., for a more detailed discussion of the various
versions of the Hatfield model.

   n1877 There is a strong (negative) correlation between population density and
the loop costs reported by all the cost models. The correlation is significant
at the 5% level. Population densities are from The Statistical Abstract of the
United States 1995, Table Number 23. For Puerto Rico, land area is from Table
361 and population is from Table 1345.

   795. A number of parties have opposed the use of either the Hatfield model or
BCM. n1878 Some critics, for   [*182]   example, have argued that the models may
lead to inaccurate cost estimates since these estimates assume that a network is
built "from scratch." n1879 Others have criticized specific procedures that have
been used in the models to estimate both operating expenses and capital costs.
As discussed below in Section VII.C.3., we believe that these criticisms may
have merit. In a future rulemaking proceeding, we intend to examine in greater
detail various forward looking economic cost models. For the purposes of setting
an interim proxy, however, we note that the criticisms have been directed
largely toward the absolute level of cost estimates produced by the models,
rather than the relative cost estimates across states. Since our hybrid proxy
ceiling explicitly scales the model cost estimates based on existing state
decisions and uses the model results simply to compute relative prices, we
believe that these criticisms do not apply in the present context.

   n1878 For a more detailed discussion of these generic cost models, see infra,
Section VII.C.3.

   n1879 See, e.g., Florida Commission comments at 28-29; USTA comments at 54
n.45; Rural Tel. Coalition reply at 35.


   796. We also note  [*183]   that a third model, the BCM 2, n1880 could have
been used in the construction of our interim cost proxy by simply taking the
scaled cost estimates from three cost models instead of two. We have chosen not
to follow this approach since parties have not had an opportunity to comment on
the possible deficiencies of the BCM 2. For comparison purposes, however, we
have computed the corresponding ceiling cost estimates, and have found that the
scaled costs using the three model proxy are very similar to the estimated costs
that were derived using the two models. n1881
   n1880 Benchmark Cost Model 2 (July 1996), submitted by Sprint Corp. and U S
West, Inc., on July 24, 1996 (BCM 2). For a more detailed discussion of this
generic cost model, see infra, Section VII.C.3.

   n1881 The coefficient of correlation is 0.991. Since the models are
deterministic, this correlation does not reflect any relevant statistical
properties of the models.

   797. As discussed above, we believe that cost-based rates should be
implemented on a geographically deaveraged basis. We allow states to determine
the number of density zones within the state, provided that they designate at
least three zones, but require  [*184]   that in all cases the weighted average
of unbundled loop prices, with weights equal to the number of loops in each
zone, should be less than the proxy ceiling set for the statewide average loop
cost set forth in Appendix D.

   798. As noted above, we have not yet had sufficient time to evaluate fully
any of the cost models that have been submitted in the record, and our hybrid
proxy is therefore intended to be used only "on an interim basis. We believe
that the methodology is consistent with forward-looking cost studies, but we
also recognize that there may be situations in which forward looking loop costs
will differ from computed costs, and accordingly, we have increased the state
average loop costs by five percent and established the proxy as a ceiling. We
emphasize that use of the hybrid proxy model can be superseded at any time by a
full forward looking economic cost study that follows the guidelines set forth
in this order. In addition, we are currently in the process of evaluating the
more detailed cost models that have been submitted in the record, n1882 and will
issue a farther notice on the use of these models in the near future.

   n1882 For a more detailed discussion of the cost models submitted in this
docket, see infra, Section VII.C.3.  [*185]

   (2) Local Switching

   (a) Comments


   799. Several IXCs propose that local switching rates be part fiat-rated and
part usage-sensitive. LDDS argues that the price of the unbundled switching
element should reflect as closely as possible the manner in which switching
costs are incurred. It believes that line-related costs should be recovered
through a flat per-line capacity charge, "based on a contracted-for number of
lines, with an additional usage-based trunking port charge and a combination of
per-line and usage-based charges to recover busy hour related costs. n1883 AT&T
similarly argues that switching rates should be based on a capacity charge for
line-specific costs plus a usage sensitive charge based on calling volume. n1884
MCI states that switching costs are a function of line connections, trunk
connections, and busy hour demand on the switch matrix and processor. Hence, the
rate for the switching element should have a sub-element price relating to each
sub-element, set to recover the associated TSLRIC. n1885 Sprint, on the other
hand, contends that the charge for the local switching element should consist of
two fiat-rated charges, one based on the number of interconnector lines
[*186]   receiving dedicated access to the first point of concentration in the
switch, and the second on the number of links between the termination equipment
and the switch that an interconnector has ordered to provide it with switching
capacity at its desired grade of service. n1886 CompTel argues that trunk port
charges should be usage sensitive because trunk ports are used by multiple
parties and that the network element for end-office serving wire center
(provided by tandem switching) should be priced on a per minute basis. n1887

   n1883 LDDS comments at 57.

   n1884 AT&T comments at 68.

   n1885 MCI comments at 30.

   n1886 Sprint comments at 35, 62.

   n1887 CompTel comments at 36, 45.

   800. Time Warner argues that pricing switched-based network elements on a
flat-rated basis could give non-facilities-based competitors artificially
created cost advantages over those who choose to invest in the development of
competing networks. n1888 It also argues that nothing in the 1996 Act suggests
that switches should not be priced based on a per-use basis rather than a
per-line or per-partitioned portion of the switch basis. n1889 NEXTLINK supports
the use of rate structures that reflect  [*187]   peak and off-peak costs, but
notes that the advantage of such structures must be balanced against the
disadvantages of complexity and possible disputes that could arise with regard
to more complex billing systems. n1890 The Washington Commission notes that the
switched access price structure for interexchange access is usage sensitive, but
it states that usage-sensitive pricing structures for switched access are
inappropriate for local interconnection services in Washington because state law
prohibits mandatory measured local service. To the extent that network element
costs are driven by peak demand, the Washington Commission states that rates
should reflect that tendency. It would prefer to see rate structures that more
accurately reflect peak, rather than average demand and has expressed a strong
interest in flat-rated port charges. The Washington Commission states that a
flat rate based upon cost of providing capacity at peak load is possibly the
most economically correct pricing mechanism; off-peak usage then is at virtually
zero cost. n1891

   n1888 Time Warner comments at 59.

   n1889 Time Warner comments at 59.

   n1890 NEXTLINK comments at 30.

   n1891 Washington Commission comments at 29-30.  [*188]

   801. LDDS and AT&T argue that there should be no additional charges for
vertical features provided by the switch, as the cost of providing those
features should already be reflected in the charge for unbundled local
switching. n1892 MCI has a similar view, arguing that, because incumbent LECs do
not incur the cost of vertical features on a usage basis, custom calling
features should be included in the price for unbundled local switching. n1893

   n1892 AT&T comments at 21 n.22; LDDS comments at 56-57.

   n1893 MCI comments at 31.



   802. Incumbent LECs and Sprint, however, argue that vertical features are
retail services offered to end users today, and must be purchased by the
competitor under the wholesale rate provision of the 1996 Act. n1894 In making
that argument, however, Sprint notes that although it is not technically
feasible to unbundle vertical services the costs of such services can be
identified and should be excluded from the price of the local switching element.
n1895 Bell Atlantic notes that services currently sold at a loss are subsidized
by vertical service offerings. It asserts that, if these offerings were treated
as unbundled elements that must be provided at  [*189]   cost instead of
wholesale retail services, then a serious takings issue would arise. n1896
ALLTEL contends that the Commission should not permit the 1996 Act's resale
price standards to be undercut by carriers attempting to mimic LEC networks by
assembling unbundled elements obtained at below cost prices. n1897 USTA contends
that section 251(e) does not allow carriers to assemble unbundled network
elements to reconstruct and provide retail services offered by the incumbent
LECs. n1898 The Competition Policy Institute argues in response, that the
existence of unbundled network elements should not be presumed to be a
substitute for a resold service. n1899 NYNEX argues that a competitor should not
be allowed to obtain resold local exchange service and ask for vertical features
at cost-based rates. It argues that the two competitive vehicles were intended
to meet different strategic needs; they were not intended to provide
opportunities for arbitrage. n1900

   n1894 See, e.g., SBC comments at 38; Sprint comments at 36-37.

   n1895 Sprint comments at 37 n.15.

   n1896 Bell Atlantic reply at Exhibit 2 (Declaration of Richard A. Epstein),
p.7.

   n1897 ALLTEL reply at 7.

   n1898 USTA reply at 8.  [*190]

   n1899 Competition Policy Institute comments at 26.

   n1900 NYNEX comments at 30, 36, 39.

   803. Several commenters included estimates of the cost for end-office
switching. MCI provides an estimate of the cost of end-office switching as
calculated by the Hatfield 2 model. n1901 Using the least cost, most efficient
technology available in the market at the time, MCI estimates that the TSLRIC of
end-office switching is equal to 0.18 cents ($ 0.0018) per minute of use. n1902
AT&T provides an updated version of the Hatfield 2 model, the Hatfield 2.2,
which treats the incumbent LECs' current wire center locations as "fixed" nodes
in a reconstructed network. n1903 Cox reports that the Hatfield 2.2 model
estimates that average TSLRIC of end office switching for most states clusters
around 0.2 cents ($ 0.002) per minute of use. n1904

   n1901 MCI comments at Attachment 1, "The Cost of Basic Network Elements,
Theory, Modeling, and Policy Implications," prepared for MCI by Hatfield Assoc.,
Inc.


   n1902 Id. at 34; see also NCTA comments at Attachment 1 (Declaration of Bruce
M. Owen), p. 34-35 (converting the Hatfield 2 estimate for end-office
switching and switch port costs into a per minute rate of 0.26 cents).  [*191]

   n1903 Hatfield Model, Version 2.2, Release 1, (Hatfield Associates, Inc.,
March 1996), submitted by AT&T and MCI on May 16, 1996 (Hatfield 2.2); see also
AT&T reply at Appendix D (Update of the Hatfield Model Version 2.2, Release 1),
p.1-3.

   n1904 Letter from J.G. Harrington, Dow, Lohnes & Albertson, on behalf of Cox
Communications, to William F. Caton, Acting Secretary, FCC, June 20, 1996, in CC
Docket No. 95-185, at Tab 2 (Review of Record on LEC Local transport and
Termination Costs Finding from LEC Cost Studies), p.3 (Cox June 20, 1996 Ex
Parte).

   804. GTE criticizes the Hatfield 2.2 model and its assumptions, arguing that
the Hatfield model suffers from serious inaccuracies and produces results that
are inconsistent with what can actually be observed. n1905 GTE reports that the
Cost Proxy Model, which was submitted by Pacific Telesis, n1906 estimates the
average cost of routing traffic through end-office switches is equal to 0.35
cents ($ 0.0035) per minute of use. n1907

   n1905 Letter from Whitney Hatch, Assistant Vice President Regulatory Affairs,
GTE, to William F. Caton, Acting Secretary, FCC, July 11, 1996 at Attachment 2
(Economic Evaluation of Version 2.2 of the Hatfield Model).  [*192]

   n1906 The Cost Proxy Model (INDETEC International, 1996), submitted by
Pacific Telesis Group on June 7, 1996 (CPM).

   n1907 Letter from Whitney Hatch, Assistant Vice President Regulatory Affairs,
GTE, to William F. Caton, Acting Secretary, FCC, July 11, 1996.at Attachment 2
(Economic Evaluation of Version 2.2 of the Hatfield Model), pp.16-17.

   805. In pleadings filed in the LEC-CMRS Interconnection proceeding, n1908 Cox
asserts that the average incremental cost of inter-office transport and
termination of traffic is 0.2 cents ($ 0.002) per minute of use. n1909 In the
same proceeding, U S West argues that Cox's estimate of 0.2 cents per minute of
use ignores the large differential between the costs of terminating calls during
peak and off-peak hours. n1910 USTA claims that the average incremental cost of
call termination is 1.3 cents ($ 0.013) per minute of use. n1911

   n1908 Interconnection Between Local Exchange Carriers and Commercial Mobile
Radio Service Providers, CC Docket No. 95-185, Notice of Proposed Rulemaking, 11
FCC Rcd 5020, 5038 (1996) (LEC-CMRS Interconnection NPRM);

   n1909 Letter from J.G. Harrington, Dow, Lohnes & Albertson, on behalf of Cox
Communications, to William F. Caton, Acting Secretary, FCC, June 20, 1996, in CC
Docket No. 95-185 at Tab 2 (Review of Record on LEC Local Transport and
Termination Costs Finding from LEC Cost Studies), pp. 1-2; see also Letter from
Robert F. Roche, CTIA, to William F. Caton, Acting Secretary, FCC, December 8,
1995, in CC Docket No. 94-54, (Incremental Cost of Local Usage, Brock Paper No.
3), p.1.  [*193]

   n1910 U S West comments in CC Docket No. 95-185 at Attachment A (A Response
to Dr. Gerald Brock), p.13.



   n1911 USTA comments in CC Docket No. 95-185 at Attachment (Bill and Keep: A
Bad Solution to a Non-Problem), pp.9-10.

   806. In response to the LEC-CMRS Interconnection NPRM, many commenters assert
that the majority of CMRS providers interconnect with incumbent LEC networks at
incumbent LECs' tandem offices. n1912 U S West asserts that Cox's estimate of
0.2 cents ($ 0.002) per minute of use underestimates the actual cost of
transporting and terminating traffic, and claims that, using the same data and
methodology as Cox, the incremental cost of transporting and terminating traffic
through the tandem is approximately three times higher than Cox's estimate.
n1913 In the same proceeding, AirTouch, relying on 1994 testimony before the
Georgia Commission, asserts that the LRIC of transporting and terminating a call
through the tandem equals approximately 0.49 cents ($ 0.0049) for the first
minute of a call and 0.12 cents ($ 0.0012) for each additional minute of use.
n1914 This estimate is based on the presumption that it should cost roughly half
as much to complete a call interchanged  [*194]   at a tandem switch as it does
to both originate and terminate a call entirely on one network. n1915 Pacific
Bell, asserts that the average LRIC for termination of calls under "Feature
Group B," which appears to include terminations at tandems switches in addition
to end-office terminations, equals 0.62 ($ 0.0062) cents per minute of use.
n1916

   n1912 See, e.g., U S West comments in CC Docket No. 95-185 at Attachment A (A
Response to Dr. Gerald Brock), p.13.

   n1913 Id.

   n1914 AirTouch comments in CC Docket No. 95-185 at 32-33.

   n1915 Id.

   n1916 Pacific Bell comments in CC Docket No. 95-185 at Exhibit B (Statement
of Professor Jerry A. Hausman) at p.14.

   807. State commissions, that have set rates for the transport and termination
of traffic, generally set rates for terminations where parties interconnect at
either the end office or the tandem office. n1917 The Maryland Commission has
set reciprocal and symmetrical rates for the transport and termination of
traffic based, among other things, on a rate proposal calculated by a staff
witness. n1918 In the Maryland proceeding, the actual cost of tandem and
end-office switch terminations are considered proprietary and  [*195]   were,
therefore, not directly reported, but the staff witness testified that the
calculation of direct, shared, and common costs is less than one-half his
proposed rate of 0.6 cents ($ 0.006) per minute of use for terminations routed
through the tandem-office switch. n1919 The Maryland Commission ultimately
adopted rates of 0.3 cents ($ 0.003) per minute of use end-office-switch
terminations and 0.5 cents ($ 0.005) per minute of use for terminations at the
tandem switch. n1920

   n1917 See, e.g., Maryland Commission comments at Appendix B (Maryland
Commission Order No. 72348, Case No. 8584 Phase II), p.28-32.

   n1918 Id.



   n1919 Id. at 29.

   n1920 Id. at 32.

   808. The Illinois Commission has adopted a rate equal to 0.5 cents ($ 0.005)
per minute of use for terminations routed directly through end-office switches
and 0.75 cents ($ 0.0075) per minute of use for calls routed through tandem
switches. n1921 Illinois's rate includes an element for recovering a
"contribution" over and above the long-run service incremental cost of
termination. n1922 Illinois arrived at its final rates by identifying the
proposed rates that would pass imputation tests. n1923 In Massachusetts, NYNEX
[*196]   testified that the average marginal cost of end-office switching equals
0.129 ($ 0.00129) cents per minute of use. n1924 Cox reports that the Florida
staff, after reviewing local service cost support data filed by GTE and
Centel/United, concluded that the sum of the estimated TSLRIC for end-office
switching and the LRIC for tandem-office switching and transport equals 0.25
cents ($ 0.0025) per minute of use. n1925

   n1921 Illinois Commission comments at Attachment C (Illinois Commerce
Commission Docket No. 94.0096), pp.83-86, 98.

   n1922 Id.

   n1923 Id. at 85.

   n1924 See Mass. Commission comments at Attachment 3 (Testimony of Paula L.
Brown, Managing Director, NYNEX Corporation, in Massachusetts Dept. of Pub.
Util. Docket No. 93-125, Workpaper 2), June 14, 1993, p.6.

   n1925 Cox June 20, 1996 Ex Parte at 4 (citing Florida Docket No. 950985-TP).

   809. The peak-period interconnection rates in New York between NYNEX and
other facilities-based, full service local exchange providers are set at 0.74
cents ($ 0.0074) per minute of use (end office) and 0.98 cents ($ 0.0098) per
minute of use (tandem). n1926 Off-peak rates are 0.27 cents ($ 0.0027) (end
office) and 0.29 cents  [*197]   ($ 0.0029) (tandem). n1927 The Michigan
Commission has established mutual compensation rates of 1.5 cents ($ 0.015) per
minute of use for calls passing directly through an end-office switch or through
tandem office switches. n1928

   n1926 Competition, The State Experience at 81 (compilation of written
responses by state commission staffs to questions by FCC staff, compiled by
NARUC) (March 8, 1996).

   n1927 Id.

   n1928 Michigan Commission comments at Attachment 1 (State of Michigan, Case
No. U-10647, Opinion and Order, February 23, 1995), p.28.

   (b) Discussion


   810. We conclude that a combination of a flat-rated charge for line ports,
which are dedicated to a single new entrant, and either a flat-rate or
per-minute usage charge for the switching matrix and for trunk ports, which
constitute shared facilities, best reflects the way costs for unbundled local
switching are incurred and is therefore reasonable. We find that there is an
insufficient basis in the record to conclude that we should require two flat
rates for unbundled local switching charges as proposed by Sprint.

   811. Based on the record in this proceeding and in the LEC-CMRS
Interconnection proceeding, we conclude  [*198]   that a range between 0.2 cents
($ 0.002) per minute of use and 0.4 cents ($ 0.004) per minute of use for
unbundled local switching is a reasonable default proxy. In setting this default
price range, we consider the range of evidence in the record, and believe that
the most credible studies fall at the lower end of this range. n1929 However, so
as to minimize disruption for any state that has set a rate only marginally
outside this range, we will grandfather any state that has set a rate at 0.5
cents ($ 0.005) per minute of use or less pending completion of an economic
study pursuant to the methodology set forth in this Order.

   n1929 See, e.g., Maryland Commission comments at Appendix B (Maryland
Commission Order No. 72348, Case No. 8548 Phase II), p.21-32; Letter from Robert
F. Roche, CTIA, to William F. Caton, Acting Secretary, FCC, December 8, 1995, in
CC Docket No. 94-54 (Incremental Cost of Local Usage, Brock Paper No. 3), p.1;
Hatfield Model, Version 2.2, Release 1, (Hatfield Associates, Inc. March 1996),
submitted by AT&T and MCI on May 16, 1996; AT&T reply at Appendix D (Update of
the Hatfield Model, Version 2.2, Release 1).

   812. The forward-looking cost studies contained  [*199]   in the record
estimate that the average cost of end-office switching ranges from 0.18 cents ($
0.0018) per minute of use n1930 to 0.35 cents ($ 0.0035) per minute of use.
n1931 Maryland and Florida have adopted rates based on forward-looking economic
cost studies that fall within the default price range we are adopting. n1932
NYNEX's estimate of 0.129 cents ($ 0.00129) per minute of use, in the
Massachusetts proceeding, is estimate an estimate of the marginal cost of
end-office switching. n1933 As discussed above, we generally expect studies
estimating marginal costs to generate estimates that are less than estimates
derived from TELRIC-based studies. We, therefore, conclude that 0.2 cents ($
0.002) per minute of use is a reasonable lower end of the price range for
end-office switching.

   n1930 See MCI comments at Attachment 1, The Cost of Basic Network Elements,
Theory, Modeling, and Policy Implications," prepared for MCI by Hatfield Assoc.,
Inc. p.34.

   n1931 Letter from Whitney Hatch, Assistant Vice President Regulatory Affairs,
GTE, to William F. Caton, Acting Secretary, FCC, July 11, 1996 at Attachment 2
(Economic Evaluation of Version 2.2 of the Hatfield Model), pp.16-17.  [*200]

   n1932 See Maryland Commission comments at Appendix B (Maryland Commission
Order No. 72348, Case No. 8584 Phase II), pp.28-32; Cox June 20, 1996 Ex Parte
at 4.

   n1933 See Mass. Commission comments at Attachment 3 (Testimony of Paula L.
Brown, Managing Director, NYNEX Corporation, in Massachusetts Dept. of Pub.
Util. Docket No. 93-125, Workpaper 2), p.6.


   813. USTA's estimate of 1.3 cents ($ 0.013) appears to be an outlier that is
significantly higher than the other estimates. n1934 We find that USTA's
estimate does not represent an appropriate cost model for termination of
traffic. USTA's estimate is based on the high end of a set of econometric
estimates of LEC-reported cost data rather than an independent cost estimate,
and USTA gives no explanation of why we should regard this as the best estimate.
In addition, USTA's figure is derived, at least in part, from studies that
attempt to measure the incremental cost of end-to-end use of the network for
local calls, not the cost of local switching. Pacific Bell's study of the
average LRIC of a call terminating under "Feature Group B" n1935 apparently
includes terminations at tandem switches in addition to end-office terminations.
[*201]

   n1934 USTA comments in CC Docket No. 95-185 at Attachment (Bill and Keep: A
Bad Solution to a Non-Problem), pp.9-10.

   n1935 Pacific Bell comments in CC Docket No. 95-155 at Exhibit B (Submission
of Jerry A. Hausman), para. 32.

   814. Michigan and Illinois have adopted rates for transport and termination
of traffic that are higher than the default price range we adopt for end-office
switching. n1936 Michigan, which established mutual compensation rates of 1.5
cents ($ 0.015) per minute of use, did not review a forward-looking cost study.
n1937 Illinois's 0.5 cents ($ 0.005) per minute rate for termination through the
end office is just outside the range we are establishing. First, as previously
stated, we are grandfathering rates of 0.5 cents ($ 0.005) per minute or lower.
Further, we do not believe Illinois's rate overrides the weight of evidence in
the record, which supports the range we are establishing.

   n1936 Michigan Commission comments at Attachment 1 (State of Michigan, Case
No. U-10647, Opinion and Order, February 23, 1995), p.28; Illinois Commission
comments at Attachment C (Illinois Commerce Commission Docket No. 94.0096),
pp.83-86, 98.

   n1937 Michigan Commission comments at Attachment 1 (State of Michigan, Case
No. U-10647, Opinion and Order, February 23, 1995), p.28.  [*202]

   815. States that do not calculate the rate for the unbundled local switching
element pursuant to a forward-looking economic cost study may, in the interim,
set the rate so that the sum of the flat-rated charge for line ports and the
product of the projected minutes of use per port and the usage-sensitive charges
for switching and trunk ports, all divided by the projected minutes of use, does
not exceed 0.4 cents ($ 0.004) per minute of use and is not lower than 0.2 cents
($ 0.002) per minute of use. A state may impose a rate for unbundled local
switching that is outside this range if it finds that a forward-looking economic
cost study shows a higher or lower rate is justified. States that use our proxy
and impose fiat-rated charges for unbundled local switching should set rates so
that the price falls within the range of 0.2 cents ($ 0.002) per minute of use
and 0.4 cents ($ 0.004) per minute of use if converted through use of a
geographically disaggregated average usage factor. A default price range of 0.2
cents ($ 0.002) per minute of use and 0.4 cents ($ 0.004) per minute of use
should allow carriers the opportunity to recover fully their additional cost of
terminating a call   [*203]   including, according to Maryland's study, a
reasonable allocation of common costs. We observe that the most credible studies
in the record before us fall at the lower end of this range and we encourage
states to consider such evidence in their analysis.



   816. With respect to the argument that vertical features should be priced
pursuant to the resale price standards, we concluded earlier that vertical
features are part of the unbundled local switching element, because they are
provided through the operation of hardware and software comprising the
"facility" that is the switch. n1938 Accordingly, the pricing standard in
252(d)(1) applies to vertical features as part of the functionality of the
switch. As previously discussed, allowing new entrants to purchase switching and
vertical features as part of the local switching network element is an integral
part of a separate option Congress has provided for new entrants to compete
against incumbent LECs. n1939

   n1938 See supra, Section V.J., discussing unbundled local switching.

   n1939 "It is unlikely that competitors will have a fully redundant network in
place when they initially offer local service, because the investment necessary
is so significant. Some facilities and capabilities . . . will likely need to be
obtained from the incumbent [LEC] as network elements pursuant to new section
251." Joint Explanatory Statement at 148.  [*204]

   817. The 1996 Act establishes different pricing standards for these two
options available to new entrants -- resale of services pursuant to section
251(c)(4) and unbundled elements pursuant to section 251(c)(3). Where the new
entrant purchases vertical features as part of its purchase of an unbundled
local switching element, the price of that element, including associated
vertical features, should be determined according to section 252(d)(1). The
availability of vertical services as part of a wholesale service offering is
distinct from their availability as part of the local switching network element.
In these circumstances, allowing the new entrant to combine unbundled elements
with wholesale services is an option that is not necessary to permit the new
entrant to enter the local market.

   818. As to Bell Atlantic's takings argument, we concluded above that the
pricing of unbundled elements according to the just and reasonable standard in
section 251(c)(2) and (c)(3), and applied in section 252(d)(1), is not an
unconstitutional taking. n1940 That analysis, which looks at the overall rates
established by our regulations, applies with equal force to the pricing of
unbundled local switching,   [*205]   inclusive of associated vertical features.
A forward-looking economic cost methodology enables incumbent LECs to recover a
fair return on their investments and Bell Atlantic has provided no specific
evidence to the contrary. We conclude that our pricing methodology for unbundled
local switching, inclusive of associated vertical features, provides just
compensation to incumbent LECs.

   n1940 See supra, Section VII.B.2.a.(3)(c).

   (3) Other Elements

   (a) Comments


   819. AT&T argues that charges for common transport should be usage sensitive,
and that signaling links, signal transfer point, and service control point
should be priced using a combination of flat-rated capacity charges and
usage-sensitive charges. n1941 The Ohio Consumers' Counsel agrees with AT&T
about the principles of rate structure," but argues that the specific
prescriptions for rate structure proposed by AT&T are unnecessary if the
principles are adopted. n1942 Sprint asserts that common transport rates should
be per-minute charges that vary with distance. n1943 MCI argues that trunk
connection costs should be recovered through a minute-of-use charge. n1944 AT&T
argues that dedicated transport rates should be non-usage  [*206]   sensitive.
n1945

   n1941 AT&T comments at 68.

   n1942 Ohio Consumers' Counsel reply at 16.

   n1943 Sprint comments at 63.

   n1944 MCI comments at 30.

   n1945 AT&T comments at 67.

   (b) Discussion

   820. The primary categories of network elements identified in this Order,
other than loops and switching, are transport, signaling, and collocation. Our
rule that dedicated facilities shall be priced on a flat-rated basis n1946
applies to dedicated transmission links because these facilities are dedicated
to the use of a specific customer.

   n1946 See supra, Section VII.B.3.

   821. For dedicated transmission links, states must use existing rates for
interstate dedicated switched transport as a default proxy ceiling. We believe
these rates are currently at or close to economic cost levels. Such rates were
set based on interstate special access rates, which we found based on the record
in the Transport proceeding were relatively close to costs. n1947 These
interstate access rates originally were based on incumbent LEC accounting costs,
rather than a forward-looking economic cost model. Since 1991, however,
incumbent LEC interstate access rates have been subject to price cap   [*207]
regulation, and have therefore been disengaged from embedded costs. n1948

   n1947 First Transport Order, 7 FCC Rcd at 7028 (1992); Transport Rate
Structure and Pricing, CC Docket No. 91-213, Third Memorandum Opinion and Order
on Reconsideration and Supplemental Notice of Proposed Rulemaking, 10 FCC Rcd
3030, 3038-39 (1994).

   n1948 Interstate access rates for dedicated transport vary by region, type of
circuit, mileage, and other factors. For example, BellSouth's entrance facility
charge, for transport from an IXC's point of presence to a BellSouth serving
wire center, is $ 134 monthly per DS1 circuit ($ 5.58 per derived voice grade
circuit) and $ 2,100 monthly per DS3 circuit ($ 3.13 per derived voice grade
circuit). Dedicated transport for 10 miles of interoffice transmission between a
serving wire center and an end office is $ 325 monthly per DS1 circuit ($ 13.54
per derived voice grade circuit) and $ 2,950 monthly per DS3 circuit ($ 4.39 per
derived voice grade circuit). Installation, multiplexing, and other
transport-related charges may also apply.


   822. Typically, transmission facilities between tandem switches and end
offices are shared facilities. Pursuant to our rate   [*208]   structure
guidelines, states may establish usage-sensitive or flat-rate charges to
recover those costs. For shared transmission facilities between tandem switches
and end offices, states may use as a default proxy ceiling the rate derived from
the incumbent LEC's interstate direct trunked transport rates in the same manner
that we derive presumptive price caps for tandem switched transport under our
interstate price cap rules, using the same weighting and loading factors. n1949
We conclude above that interstate direct-trunked transport rates provide a
reasonable default proxy ceiling for unbundled dedicated transport rates. When
we restructured the incumbent LECs' interstate transport rates to be more
closely aligned with cost, we derived presumptive tandem-switched transmission
rate levels from direct-trunked transport rates. n1950 This proxy ceiling for
shared transmission facilities between tandem switches and end offices,
therefore, should be similarly derived.

   n1949 Specifically, when the transport rate restructure was implemented, the
initial levels of tandem-switched transmission rates were presumed reasonable if
they were based on a weighted per-minute equivalent of direct-trunked transport
DS1 and DS3 rates that reflects the relative number of DS1 and DS3 circuits used
in the tandem to end office links, calculated using a loading factor of 9000
minutes per month per voice-grade circuit. 47 C.F.R. @ 69.111.  [*209]

   n1950 First Transport Order, 7 FCC Rcd at 7018-19. Interstate access rates
for tandem-switched transport vary by region and mileage. The average charge by
RBOCs in Density Zone 1 for transport termination and one mile of switched
common transport facility between a tandem switching office and end office
equals 0.033 cents ($ 0.000331) per minute. For a five-mile facility, the
average charge is 0.048 cents ($ 0.000479) per minute; for a ten-mile facility,
0.066 cents ($ 0.000664) per minute.

   823. The United States Court of Appeals for the District of Columbia Circuit
recently remanded our interim transport rules. n1951 The court concluded that
the Commission had not provided sufficient justification for its method of
establishing the rate level of the interstate switched access rate element for
tandem switching. n1952 We do not believe, however, that the CompTel v. FCC
decision is inconsistent with the rules we establish here because the decision
did not address or criticize the Commission's determination of the rates for
dedicated transport or tandem-switched transport links. Because our proxies do
not involve the interstate access rate for tandem switching, they are not
inconsistent  [*210]   with the court's analysis.

   n1951 Competitive Telecommunications Ass'n v. FCC, No. 95-1168 (D.C. Cir.
April 28, 1996).

   n1952 The court accepted both AT&T's claim that the Commission had not
justified the allocation of 80 percent of the tandem revenue requirement to the
TIC and only 20 percent to the tandem element, and CompTel's argument that the
Commission had not justified its allocation of overheads to the tandem element.


   824. Tandem switching also employs shared facilities. States may, therefore,
establish usage-sensitive charges to recover tandem-switching costs. For those
states that cannot complete a forward-looking economic cost study within the
arbitration period or cannot devote the necessary resources to such a review, we
establish a default rate ceiling of 0.15 cents ($ 0.0015) per minute of use. The
additional cost of termination at a tandem in comparison to termination at an
end office consists of the cost of tandem switching and the cost of
tandem-switched transport transmission. Illinois and Maryland have adopted
rates for the transport and termination of traffic from the tandem switch that
are, respectively, 0.25 cents ($ 0.0025) per minute of use and 0.2  [*211]
cents ($ 0.002) per minute of use, higher than rates for termination at end
office switches. n1953 In both instances, our default rate ceiling for tandem
switching constitutes at least 60 percent of the implicit tandem switching and
transport to the end office switch. We, therefore, find the default rate ceiling
we adopt for tandem switching to be consistent with both Illinois's and
Maryland's adopted rates for transport and switching of traffic from the tandem
office. States that use our proxy and impose flat-rated charges for tandem
switching should set rates so that the price does not exceed 0.15 cents ($
0.0015) per minute of use if converted through use of a geographically
disaggregated usage factor.

   n1953 Illinois Commission comments at Attachment C (Illinois Commerce
Commission Docket No. 94.0096), pp.83-86, 98; Maryland Commission comments at
Appendix B (Maryland Commission Order No. 72348, Case No. 8548 Phase II),
pp.28-32.

   825. Rates for signaling and database services should be usage-sensitive,
based either on the number of queries or the number of messages, with the
exception of the dedicated circuits known as signaling links, which should be
charged on a flat-rated  [*212]   basis. Usage charges of this type appear to
reflect most accurately the underlying costs of these services. n1954 Interstate
access rates for most of these elements have been justified using the price caps
new services test, which roughly approximates the results of a forward-looking
economic cost study. n1955 In addition, the costs of these services were
forward-looking, in that the services were completely new and hence, by
definition, used the best-available technology. Thus, we establish as a default
proxy ceiling for these elements corresponding interstate access charges for
these elements. n1956 For elements that have not been subject to the new
services test, states may establish proxy ceilings by identifying the direct
costs of providing the element and adding a reasonable allocation of joint and
common costs. Because we expect that the joint and common costs associated with
the forward-looking cost of network elements are substantially less than those
associated with traditional service-based costs, n1957 allowing a reasonable
allocation is sufficient to protect against possible anticompetitive pricing.
Absent any proxy, this approach will provide the most reasonable approximation
[*213]   of forward-looking economic cost.

   n1954 Ameritech Operating Companies Petition for Waiver of Part 69 of the
Commission Rules to Establish Unbundled Rate Elements for SS7 Signalling, DA
96-446, Order, at para. 31 (Corn. Car. Bur., rel. Mar. 27, 1996).

   n1955 Amendments of Part 69 of the Commission's Rules Relating to the
Creation of Access Charge supplements for Open Network Architecture, CC Docket
Nos. 89-79 and 87-313, Report and Order, Order on Reconsideration, and
Supplemental Notice of Proposed Rulemaking, 6 FCC Rcd 4524, 4531 (1991);
modified on recon., 7 FCC Rcd 5235 (1992); Open Network Architecture Tariffs of
Bell Operating Companies, CC Docket No. 92-91, Order, 9 FCC Rcd 440, 454-456
(1993).

   n1956 Interstate database services consist of Line Information Database
(LIDB) and 800 Database. Deployment of SS7 (out-of-band signaling) has enabled
LECs to offer these services. The average charge for RBOCs for LIDB in Density
Zone I equals 3.34 cents ($ 0.034) per database query.



   n1957 See supra, Section VII.B.2.a.

   826. We have established rate structure rules for collocation elements in
connection with our Expanded Interconnection proceeding. n1958 Many collocation
[*214]   elements established under section 251(c)(6) are likely to represent
the same facilities, and should have the same cost characteristics, as existing
interstate expanded interconnection services, and therefore we require states to
use the same rate structure rules for those collocation elements that we
established in the Expanded Interconnection proceeding. As a proxy ceiling,
states may use the rates the LEC has in effect in its federal expanded
interconnection tariff for the equivalent services. Expanded interconnection
services are subject to the new services test, which, as discussed above, uses a
forward-looking methodology. Although LECs have filed expanded interconnection
tariffs, we have not yet completed our investigation into those tariffs. Any
price for unbundled collocation elements set based on LEC expanded
interconnection tariffs would therefore be subject to any modification of those
tariffs that results from our pending investigation, and any state-imposed
prices based on those tariffs will need to be adjusted accordingly.

   n1958 Expanded Interconnection with Local Telephone Company Facilities, CC
Docket No. 91-141, 9 FCC Rcd 5154, 5186 (1994).

   827. We find it   [*215]   unnecessary to specify rate structures for other
unbundled elements. The states shall make those determinations by applying our
general rate structure principles described above. In the absence of an
acceptable forward-looking cost study, states may establish default proxy
ceilings for other unbundled elements by identifying the direct costs of
providing the element and adding a reasonable allocation of joint and common
costs.

   3. Forward-Looking Cost Model Proxies

   a. Background and Comments

   828. In the NPRM, we sought comment on the use of certain generic cost
studies. Commenters discussed several such models. These models include: 1) the
Hatfield 2; n1959 2) the Hatfield 2.2; n1960 3) the BCM; n1961 4) the BCM 2;
n1962 and 5) the CPM. n1963

   n1959 The Cost of Basic Network Elements: Theory, Modeling, and Policy
Implications (Hatfield Associates, Inc., March 1996), submitted by MCI on March
29, 1996 (Hatfield 2).

   n1960 Hatfield Model, Version 2.2, Release 1, (Hatfield Associates, Inc.,
March 1996), submitted by AT&T and MCI on May 16, 1996 (Hatfield 2.2); see also
AT&T reply at Appendix D (Update of the Hatfield Model Version 2.2, Release 1).

   n1961 Benchmark Cost Model: A Joint Submission by MCI Communications, Inc.,
NYNEX Corporation, Sprint Corporation, U S West, Inc. (December 1995), submitted
by MCI Communications, Inc., NYNEX Corp., Sprint/United Management Corp., U S
West, Inc. on July 24, 1996 (BCM).  [*216]

   n1962 Benchmark Cost Model 2 (July 1996), submitted by Sprint Corp. and U S
West, Inc., on July 24, 1996 (BCM 2).



   n1963 The Cost Proxy Model (INDETEC International, 1996), submitted by
Pacific Telesis Group on June 7, 1996 (CPM).

   829. Generic Cost Models. Several generic forward-looking costing models were
introduced into the record. Several commenters, supporting the use of generic
cost models to establish the rates that incumbent LECs may charge for
interconnection and unbundled elements, claim that such an approach would result
in ceilings that are efficient, objective, and based on non-proprietary inputs.
n1964 On the other hand, certain commenters argue that generic cost models
should not be used as proxies because they fail to reflect the possible
differences in costs among states, and among carriers, due to technical,
demographic, and geographic factors. n1965 In addition, many parties also
discussed the use of proxies as direct substitutes for the prices of
interconnection and unbundled network element rates. n1966

   n1964 See, e.g., Ad Hoc Telecommunications Users Committee comments at 50;
PacTel comments at 76; Ohio Consumers' Counsel comments at 28-29.

   n1965 See, e.g., Bay Springs, et al. Comments at 16-17; Cincinnati Bell
comments at 28; Florida Commission comments at 30; Telecommunications Resellers
Ass'n comments at 41; California Commission reply at 19.  [*217]

   n1966 See, e.g., AT&T comments at 53.

   830. The Hatfield Models. n1967 Parties also commented on the particular
generic cost models placed on the record in this proceeding, and several support
the use of a version of the Hatfield model. n1968 These parties argue that the
Hatfield model represents the only comprehensive nationwide analysis of
virtually all network elements on a highly disaggregated basis and is the ideal
standard for the Commission to adopt because it will provide immediate certainty
on pricing. n1969 Other commenters oppose the application of a version of the
Hatfield model, n1970 asserting that it may not accurately reflect an incumbent
LEC's decisionmaking process for determining the economic and technical
feasibility of interconnection because it assumes building "from scratch," an
assumption potentially leading to inaccuracy. n1971 Critics of the various
Hatfield models also argue that they results in below-cost rates for services,
n1972 do not capture embedded costs, n1973 and employ a nationwide industry
average for costs when costs should be based on the particular carrier's costs.
n1974

   n1967 We note that many parties did not address their comments to a
particular version of the Hatfield model. In such cases, we will refer generally
to the Hatfield model.  [*218]

   n1968 See, e.g., ACSI comments at 56; AT&T comments at 53 (commenting on
Hatfield 2.2); MCI comments at 68-69 (commenting on Hatfield 2); NEXTLINK
comments at 27-28; Washington Commission comments at 27.

   n1969 See, e.g., MCI comments at 69 (commenting on Hatfield 2).

   n1970 See, e.g., PacTel comments at 74-76, reply at 30 (commenting on
Hatfield 2.2); Ohio Consumers' Counsel comments at 29 n.10; USTA comments at 54
n.45; Sprint reply at 31-32; Rural Tel. Coalition reply at 35.



   n1971 See, e.g., Florida Commission comments at 28-29; Lincoln Tel. reply at
6; Rural Tel. Coalition reply at 35; USTA comments at 47-48, 54 n.45.

   n1972 See, e.g., Lincoln Tel. reply at 6; U S West comments 20-22.

   n1973 See, e.g., USTA comments at 54 n.45; Rural Tel. Coalition reply at 35;
PacTel reply at 30 (commenting on Hatfield 2.2).

   n1974 See, e.g., GVNW reply at 12-13; Lincoln Tel. reply at 6; Sprint reply
at 28-32.

   831. GTE argues that the Hatfield 2.2 model's assumptions and analytic
practices result in an understatement of cost per loop of about $ 8.00. n1975
GTE criticizes the assumption that all traffic carried by LECs will be served by
a brand new entrant that instantly  [*219]   materializes. GTE indicates that
such an assumption would not produce results that are representative of
incumbent LEC costs when providing services and unbundled elements. GTE argues
that the Hatfield 2.2 model's use of multiplicative factors to calculate
installation costs produces inaccuracies, to the extent that the basis of these
factors depart from historical relationships. In addition, GTE asserts that the
equipment prices used in the Hatfield 2.2 model are consistently lower than
prices paid by LECs. Moreover, GTE asserts that the capital cost and
depreciation rates of the Hatfield 2.2 model do not reflect costs of capital and
depreciation rates that will prevail under competitive conditions. n1976
Finally, it asserts that the Hatfield 2.2 model uses unrealistically high fill
factors (the percentage of capacity used), which results in an understatement of
investment and, hence, annualized cost. n1977

   n1975 Letter from Whitney Hatch, Assistant Vice President Regulatory Affairs,
GTE, to William F. Caton, Acting Secretary, FCC, July 11, 1996 at Attachment 2
(Economic Evaluation of Version 2.2 of the Hatfield Model).

   n1976 Id. at 13-16.

   n1977 Id. at 9-12.

   832. The  [*220]   Benchmark Cost Models. n1978 Although some parties support
the use of the BCM to set rates for interconnection and unbundled elements,
n1979 many other parties oppose its use for this purpose. n1980 Several
commenters argue that, because the BCM was designed to identify only high cost
areas, its assumptions are flawed and will fail to reflect small and rural LECs'
network characteristics. n1981 NYNEX argues that the BCM is based on a limited
set of assumptions about the costs that affect loops. n1982 Commenters further
contend that the BCM is not technology neutral, n1983 is not designed to
estimate the costs of serving business customers, n1984 assumes one type of
central office switch, n1985 and uses ARMIS cost loading factors that assume
that costs are spread over the existing, larger investment base. n1986

   n1978 We note that many parties did not address their comments to a
particular version of the BCM. In such cases, we will refer generally to the
BCM.

   n1979 See, e.g., ACSI comments at 56; Sprint comments at 54 n.30; Texas
Public Utility Counsel comments at 29.



   n1980 See, e.g., Florida Commission comments at 29-30; GVNW comments at
38-39; NYNEX comments at 57; Ohio Consumers' Counsel comments at 29, n.10;
PacTel comments at 74-76; SBC comments at 92-93; TDS comments at 22; Rural Tel
Coalition comment at 22, reply at 34-35.  [*221]

   n1981 See, e.g., Rural Tel. Coalition comments at 22; TDS comments at 22; see
also Time Warner comments at 54-55; USTA comments at 54 n.45.

   n1982 NYNEX comments at 57; see also SBC comments at 92-93.

   n1983 See, e.g., WinStar comments at 34; Texas Statewide Tel. Cooperative,
Inc. comments at 14.

   n1984 See, e.g., NYNEX comments at 57.

   n1985 Id.

   n1986 Id.

   833. Cost Proxy Model (CPM). Pacific Telesis maintains that its CPM is a
superior alternative to the Hatfield models and BCM models because it is more
flexible, can be based on non-proprietary information, can be independently
audited, can estimate the cost of providing local telephone service for
one-fourth (1/4) mile grids or large geographic areas, and reflects the actual
locale of subscribers within a census block. n1987

   n1987 PacTel comments at 76.

   b. Discussion

   834. We believe that the genetic forward-looking costing models, in
principle, appear best to comport with the preferred economic cost approach
discussed previously. Several such models were placed in the record, including
Hatfield 2, Hatfield 2.2, BCM, BCM 2, and the CPM. The BCM is designed to
produce "benchmark" costs for the provision  [*222]   of basic telephone service
within specific geographic regions defined by the Bureau of the Census as Census
Block Groups. The Hatfield 2 model combines output from the BCM with
independently-developed investment data to produce annual cost estimates for
eleven basic network functions. The CPM is similar in structure to the BCM and
Hatfield 2 models, although it uses different algorithms.


   835. These models appear to offer a method of estimating the cost of network
elements on a forward-looking basis that is practical to implement and that
allows state commissions the ability to examine the assumptions and parameters
that go into the cost estimates. Although these models were submitted too late
in this proceeding for the Commission and parties to evaluate them fully, our
initial examination leads us to believe that the remaining practical and
empirical issues can be resolved in the near future. In light of the advantages
of such a genetic approach, we will further examine these generic economic cost
models by the first quarter of 1997 to determine whether we should use one of
them to replace the default proxies we adopt in this proceeding. In that event,
states would have the option  [*223]   of setting rates in arbitrations on the
basis of an economic cost study or by using a generic forward-looking cost model
approved at that time. n1988
   n1988 We note that we address certain criticisms of the models in the context
of their use in the development of the proxy for the unbundled local loop,
supra, Section VII.C.2.b.(1)(b).

   836. Finally, we note that Commission staff developed a model of the
telecommunications industry that they designed to simulate industry demand and
supply characteristics. n1989 In order to encourage an open-ended discussion of
the utility of the staff model, the Common Carrier Bureau sought comment on a
working draft of the model that was released. Almost all parties commenting on
the staff model urged the Commission not to rely upon the staff model as record
evidence in this proceeding. n1990 We are not relying on the staff model to
develop the requirements imposed by this Order.

   n1989 See Public Notice, Supplemental Comment Period Designated for Local
Competition Proceeding, CC Docket 96-98, DA 96-1007 (rel. June 20, 1996). The
comment period was extended subsequently to July 8, 1996. See Public Notice,
Supplemental Comment Period Extended for Local Competition Proceeding, CC Docket
96-98, DA 96-1030 (rel. June 25, 1996). The Commission did not authorize reply
comments.  [*224]

   n1990 See, e.g., Ameritech July 8 comments at 14; NCTA July 8 comments at 2;
PacTel July 8 comments at 21; see also New York Commission July 8 comments at
1-2 (Commission should institute "collaborative process" whereby federal, state,
and industry participants can review model and develop alternatives).

D. Other Issues

   1. Future Adjustments to Interconnection and Unbundled Element Rate Levels

   a. Background and Comments

   837. In the NPRM, we sought comment on whether some cost index or price cap
system would be appropriate to ensure that rates reflect expected changes in
costs over time. n1991 Only two parties commented on this issue, and neither
supported establishment of a price cap system or other index system to adjust
rates over time. MCI claims that it is not necessary to recompute TSLRIC costs
each year. It argues that large productivity factors are not needed as they are
in price cap system, because initial access rates were based on embedded costs,
which greatly exceed economic costs. MCI proposes that the Commission should use
initial rates as ceilings for a three to five year period. It contends that, if
competition develops satisfactorily, there may not be a   [*225]   need to
revisit the costing process. On the other hand, MCI suggests that if it appears
that LECs retain substantial market power, a performance review could become
necessary. n1992 Ad Hoc Telecommunications Users Committee notes that the
success of any price cap plan would depend on the accuracy of the productivity
offset. It states that an inappropriately low productivity offset could result
in excessive charges. n1993

   n1991 NPRM at para. 133.

   n1992 MCI comments at 68.

   n1993 Ad Hoc Telecommunications Users Committee comments at 31.



   b. Discussion

   838. As noted earlier, we will continue to review our pricing methodology,
and will make revisions as appropriate. Accordingly, there is no present need to
establish a Commission price cap or cost index system to adjust interconnection
and unbundled element rate levels.

   2. Imputation

   a. Background

   839. We sought comment in the NPRM on whether we should require an
"imputation role" in establishing rates for unbundled network elements. n1994 An
imputation rule would require that the sum of prices charged for a basket of
unbundled network elements not exceed the retail price for a service offered
using the same basket of elements.   [*226]   We further solicited comment on
any other rules that could be adopted regarding pricing of unbundled network
elements that would help to promote the pro-competitive goals of the 1996 Act.

   n1994 NPRM at para. 184.

   b. Comments

   840. Commenters favoring an imputation role, including some IXCs and other
potential entrants, and one state utility counsel, argue that imputation is
necessary to prevent potential anticompetitive practices highlighted in the
NPRM, such as price squeezes and predatory pricing by incumbent LECs. n1995
Several commenters also endorsed imputation as a method of testing whether rates
are reasonable. n1996 Sprint argues that, unless the Commission imposes an
imputation rule, incumbent LECs will have little incentive to pursue rate
rebalancing activities vigorously before state commissions. n1997 Teleport urges
the Commission not to assume that new entrants possess sufficient financial
resources to survive a price squeeze and suggests that, if a carrier fails an
imputation test, the Commission should find that the market is not sufficiently
competitive to allow incumbent BOC entry into the in-region long distance
market. n1998

   n1995 See e.g., ACSI comments at 56-57; ACTA comments at 26; Frontier
comments at 29-30; NEXTLINK comments at 33; Telecommunications Resellers Ass'n
comments at 26; Teleport comments at 60-63; Texas Public Utility Counsel
comments at 47-48. MCI comments at Attachment 1 (The Cost of Basic Network
Elements: Theory, Modeling and Policy Implications), pp.6-7 (arguing that
imputation is necessary, but not sufficient, to prevent price squeezes).
[*227]

   n1996 See, e.g., Intermedia Comments at 14; Sprint Comments at 72-74.

   n1997 Sprint reply at 44.

   n1998 Teleport comments at 60-63.