Understanding Universal Service: The U.S. Experience and Regulatory Framework

1. WorldCom Presentation to the LRIC Working Group Michael D. Pelcovits, Ph.D. Vice President and Chief Economist Tokyo, Japan December 13, 2000

2. Overview • Universal Service - The US Experience • Setting Depreciation Rates • Traffic-sensitive and non-traffic sensitive costs • Outside Plant Types

3. Universal Service - The U.S. Experience

4. Overview • US Regulatory Background • Defining Universal Service • Calculating Universal Service Costs • Determining Subsidy Amount • Funding and Distributing Universal Service Support

5. US Regulatory Background • Historically, low prices for local exchange services were subsidized by above-cost pricing of long-distance and other services • Upon AT&T divestiture, access charges imposed on long-distance companies replaced much of this subsidy

6. US Regulatory Background • Dual responsibility for universal service • Federal government has jurisdiction over interstate services, mainly long distance and access (interconnection) to long distance carriers • State governments have jurisdiction over local services, short-haul toll and access for short-haul toll • Joint Board of state and federal regulators is convened to address issues of joint responsibility

7. US Regulatory Background • Telecommunications Act of 1996 required: • Implicit subsidies to be replaced by explicit subsidies • Competitively neutral assessment of support • Competitively neutral availability of funds • Cost of subsidy determined without reference to rate base or rate of return

8. Voice-grade access to network Touch-Tone dialing Single-party service Access to emergency services Access to operator services Access to long-distance carriers Access to directory assistance Defining Universal Service Federal-State Joint Board defined “supported services” as:

9. Defining Universal Service • In subsequent proceedings, the definition of universal service was expanded to include the ability to access data services at 56kbps or higher

10. Defining Universal Service • U.S. also provides targeted programs to low-income subscribers • LifeLine - reduced rate, limited usage service • LinkUp - reduction or waiver of initial installation costs • Schools and libraries • Universal service fund provides support for Internet connectivity

11. Universal Service Costs • Prior to Telecomm Act of 1996, subsidies were based on embedded (accounting) cost • Federal subsidies based on allocation of loop cost to federal jurisdiction • State subsidies determined through “residual ratemaking”

12. Universal Service Cost • Joint Board was concerned that basing universal service support on embedded cost would fund inefficient operations • Use of forward-looking economic cost encourages efficient operation by all carriers • Provide incentives to incumbents to improve efficiency • Discourage inefficient entry decisions by competitors

13. Universal Service Cost • Joint Board found that a cost model should be used to estimate universal service cost • Provides greater geographic disaggregation than accounting data • Competitively neutral, because not based on any one carrier’s network

14. Universal Service Cost • FCC adopted 10 criteria for assessing cost models • Technology - least-cost, most efficient technology for providing supported services, with “scorched node” topology • All network functions must have an associated cost • Cost estimated is long-run, forward looking economic cost

15. Universal Service Cost • 10 criteria (continued) • Rate of return set at FCC’s approved level of 11.25% • Depreciation lives and net salvage rates should be in FCC-prescribed range • Model should include all services provided by the network, to reflect economies of scale

16. Universal Service Cost • 10 Criteria (continued) • Reasonable allocation of joint and common costs to supported services • Model should be open -- all calculations and software open to inspection and review, all input data verifiable • Critical assumptions and input variables must be changeable • Disaggregation of results at least to the level of the wire center

17. Determining Subsidy Amount • Much of FCC’s system for determining subsidy amount is specific to peculiar nature of US dual jurisdictional system • In general… • Each state computes average forward-looking cost • National benchmark is set at 135% of national average forward-looking cost • Federal support is available for 76% of per-line forward-looking cost > 135% of national average

18. Determining Subsidy Amount • After total amount of state subsidy is determined, support is targeted to high cost wire centers • Ensures that support goes only to lines that require support • Wire centers with cost < national benchmark receive no support • Wire centers with cost > national benchmark receive support proportional to the degree to which costs exceed the national benchmark

19. Funding & Distribution of Support • Total nationwide support requirements are funded by an assessment on each carrier’s interstate and international revenues derived from end users • Access charges reduced to account for replacement of implicit subsidies with explicit subsidies

20. Funding & Distribution of Support • All universal service support is portable among carriers • If a competitive carrier takes a customer in a high-cost area from the incumbent…. • Or if a competitive carrier sells new services in a high-cost area… • That carrier is eligible for the same high-cost support that would be available to the incumbent

21. Size of Universal Service Funds • High-cost support = $1.9 billion • Non-rural carriers = $399 million • Rural carriers = $1.5 billion • Schools & Libraries = $2.25 billion • Low-income support = $672 million • LifeLine = $632 million • LinkUp = $40 million

22. Conclusions • US Universal Service support is competitively neutral • Costs determined using forward-looking methodology, not specific to any carrier • Subsidy Amount is equitable among states and among carriers • Funding of support is through assessment on all carriers • Distribution of support is portable and equitable among carriers

23. Setting Depreciation Rates

24. Depreciation in the U.S. • FCC Depreciation Policies and Practices • Results for Regulated Local Exchange Carriers (LECs) • Comparison to WorldCom Depreciation Practices

25. FCC Depreciation Policies & Practices • Concepts • Whole Life • The useful life of plant at the time the plant is purchased • Depreciation expense computed under this method equals (Original Investment - Net Salvage) / Useful Life of the Plant

26. FCC Depreciation Policies & Practices • Concepts • Remaining Life • The useful life of plant remaining as of the time of a depreciation study • Depreciation expense using this method equals (Original Investment - Accumulated Depreciation - Net Salvage) / Average Remaining Life of the Plant

27. FCC Depreciation Policies & Practices • Concepts • Net Salvage • The amount for which plant can be sold at the end of its useful life minus the cost of removal • Can be positive (switches can be sold and used by other phone companies) or negative (poles must be removed and disposed of)

28. FCC Depreciation Policies & Practices • Concepts • Survivor Curves • Mathematical formula that predicts what percentage of a given vintage of plant will be removed from service in a given year • In the United States, typically an S-shaped curve

29. FCC Depreciation Policies & Practices • Before 1981 • Rates based on whole life • Resulted in insufficient depreciation as equipment lives shortened

30. FCC Depreciation Policies & Practices • After 1981 • Changed to remaining life • Prevented insufficient depreciation • Amortizations used to make up previous shortfall

31. FCC Depreciation Policies & Practices • After 1981 (cont’d) • Lives, salvage values, and survivor curves decided in triennial meetings • FCC, State regulators, Company • opportunity for comment by public • determined by plant account

32. FCC Depreciation Policies & Practices • After 1981 (cont’d) • LEC provided information on historical and projected retirements • Adopted lives strongly influenced by projected retirements • prescribed lives match historical retirements only 30 percent of the time

33. FCC Depreciation Policies and Practices • To support their proposed depreciation lives, companies provide, by plant account • Five most recent years of actual data on plant and reserves • Three year forecast of additions, retirements, and plant • Actual and projected data on salvage and cost of removal

34. FCC Depreciation Policies and Practices • Companies also provide a description of any market or technological changes that will affect future retirements

35. FCC Depreciation Policies and Practices

36. FCC Depreciation Policies and Practices

37. FCC Depreciation Policies and Practices

38. FCC Depreciation Policies and Practices

39. FCC Depreciation Policies & Practices • Depreciation Simplification - 1993 • To reduce reporting burden, FCC simplified depreciation process • Set ranges for depreciation lives and net salvage values based on already approved values • average values by plant account, plus or minus one standard deviation

40. Adopted Ranges

41. FCC Depreciation Policies & Practices • Depreciation Simplification - 1993 (cont’d) • Less support required if claimed lives and net salvage are within the ranges • For claimed values outside the range, the previous level of support is required • Bell companies have claimed lives at the low end of these ranges, with few changes in the last four years

42. Results for Regulated LECs • ILEC reserves have grown faster than investment in plant..

43. Results for Regulated LECs • ...Leading to an increase in ILEC Reserve Ratios (Reserves/TPIS)

44. Overall cost of capital • Cost of capital in US cost models includes: • Economic depreciation expense • Levelized equity return and interest on invested capital • Converted to level annual cost using an annuity calculation • Income taxes on equity return

45. Comparison to WorldCom Depreciation Practices • ILEC Depreciation Lives for Circuit Equipment, Cable, and Poles - 65% of ILEC plant - are shorter than those used by WorldCom • Depreciation lives used in the NTT Cost Model are shorter than ILEC lives

46. Comparison to WorldCom Depreciation Practices

47. Traffic-sensitive and Non-Traffic sensitive Costs

48. Overview • Importance of proper classification • Classification of Outside Plant equipment • Classification of Central Office equipment • Implications for pricing structure

49. Importance of Proper Classification • Fundamental element of any cost study is to identify cost drivers: • What kind of demand causes costs to vary? • Are multiple demand factors implicated in cost changes? • What’s the functional relationship between changes in demand and changes in cost?

50. Importance of Proper Classification • As a general principle - cost recovery should match cost causation • Encourages efficient consumption behavior • Prevents under- or over-recovery of costs • Sends correct pricing signals to new competitive entrants