THE ROLE OF THE BENCHMARK COST MODEL
IN ADDRESSING UNIVERSAL SERVICE
FUNDING REQUIREMENTS

1.1 Background

The Federal Communications Commission and a number of state regulatory bodies have identified the need for an objective measure of the cost of providing basic local exchange service, in order to properly gauge the need for and size of an explicit universal service funding mechanism.[1] The enactment of the Telecommunications Act of 1996[2] on February 1, 1996 further underscores the need to quantify the level of support required to ensure the provision of affordable basic service to all households throughout the country, while enabling competition to evolve efficiently in local markets.[3] Although there is a general consensus on the need for a reliable cost study of basic local exchange service, not surprisingly, there is substantial disagreement as to the specifics of any particular costing method or process. Nonetheless, despite the difficulties of reaching agreement on algorithms, cost inputs, and other attributes of a cost study, on September 12, 1995, four companies (including local exchange carriers and interexchange carriers) jointly submitted a cost proxy model known as the Benchmark Cost Model (BCM) to the FCC. MCI Communications Inc., NYNEX Corporation, Sprint/United Management Co., and US West, Inc. (the "Joint Sponsors") submitted a description of the BCM, the BCM itself, and the data inputs and results for six states to the FCC in CC Docket No. 80-286 (the so-called "High Cost proceeding"). On November 1, 1995, the Joint Sponsors made a second filing with data and results for an additional 17 states, and on December 1, 1995, they made a filing with data for 49 states and the District of Columbia.[4] The initial filing was the subject of comments by participants in the FCC's High Cost proceeding.[5]

Subsequently the BCM has been introduced in several state universal service fund (USF) proceedings, where it has been the subject of varying levels of scrutiny.[6] The BCM is currently receiving particular attention in California, where Pacific Bell has developed its own "Cost Proxy Model" (CPM) and a diverse coalition of non-LEC parties is jointly supporting a variation of the BCM known as the "Hatfield Proxy Model."[7]

The BCM is by no means the sole cost proxy study that is being proposed to address universal service funding requirements. As noted, Pacific Bell has submitted its own cost study in the California USF proceeding, and in other jurisdictions, several local exchange carriers have been directed to or have already submitted cost studies of their own. One of the challenges for federal and state policy makers will be to determine the degree to which any given national USF cost model should reflect state-specific variations.

The purposes of the BCM, according to the Joint Sponsors, are to:

(1) Identify areas likely to require explicit high-cost assistance.

(2) Provide a benchmark cost range "assuming efficient engineering and design criteria and deployment of current state-of-the-art loop and switching technology, using the current national local exchange network topology."

(3) Provide a "benchmark measurement of the relative costs of serving customers residing in given areas, i.e., the CBGs."[8] According to the Sponsors, the purpose of the BCM is not to "define the actual cost of any telephone company, nor the embedded cost."

(4) Reflect only residential lines.[9] (According to the model's sponsors, the impact of excluding business lines is de minimis.)[10]

Reliance upon embedded cost studies would not satisfy the important purpose of a cost proxy model, which is to provide an objective, forward-looking measure of the ongoing cost of supporting the universal service goal, assuming efficient engineering and design. Embedded costs reflect past engineering and acquisition decisions that have either been made obsolete by fundamental changes in telecommunications technology, as well as capital investment initiatives that may have been driven more by the then-extant form of regulation[11] and by business goals of the individual LECs having little direct bearing upon achieving universal residential exchange service penetration.

A cost proxy model is well-suited to the complex task of unravelling existing implicit subsidies and quantifying the amount of explicit support that is required to move forward into the era of competition in the local market. Overstating the need for federal and state USF requirements would thwart the national goal of promoting competition. Understating the USF need could jeopardize the achievement of universal service.[12] A cost proxy model, by reflecting objective measures of providing basic residential local exchange service, will allow the FCC and the state public utilities commissions (PUCs) to size and to target assistance where it is needed, without unnecessarily burdening consumers and providers of basic local telecommunications service.

This report assesses the strengths and weaknesses of the BCM, discusses the compatibility of the BCM with the Telecommunications Act of 1996, and identifies certain corrections that should be made to the BCM before it is adopted as a tool in federal and state USF deliberations. The report examines key variables in the BCM (whether "hard-wired" or "user-specified") and major algorithms that merit the closest scrutiny by policy makers. Where feasible, this report also offers affirmative alternative approaches that, if incorporated into a revised cost proxy analysis, will result in a BCM that more accurately models the cost of satisfying the universal service goal.

It is also important to recognize that the BCM does not purport to address many key questions relating to the establishment of an explicit USF. The BCM is potentially a valuable tool that can contribute substantially to the USF debate, but the Joint Sponsors have neither raised nor answered some major relevant questions. The Joint Sponsors indicate further that they "support the use of the BCM for the analysis of the targeting of explicit high cost support." However, the Joint Sponsors also indicate that they "do not agree on its use for other purposes such as the setting of rates for telephone service."[13] This report not only evaluates the BCM, but also provides answers to some of the more challenging questions that are key to ultimately sizing and establishing explicit universal service support programs.

Although this report offers a critical examination of the BCM, the authors also recognize that no cost model will ever be "perfect." The challenge for the policy maker is to determine when a cost proxy model has become sufficiently robust that it is time to adopt the model and move forward. While it would be counterproductive to adopt a model prematurely (i.e., before it satisfies appropriate standards),[14] it would also detract from other important aspects of the universal service debate should efforts to fine-tune any particular model become excessively prolonged.

The timing for implementation of a universal service funding mechanism has itself engendered debate and, in light of the up-front effort that has been required in order to create a reliable costing tool, should be put in the proper perspective. Some incumbent local exchange carriers have repeatedly claimed in state USF proceedings that local competition will jeopardize universal service.[15] They therefore argue that a universal service funding mechanism needs to be in place from the very outset, as a threshold condition for the authorization of any competition at the local level. Of course, any impact on universal service that may result from competition, to the extent that it occurs at all, will not happen precipitously or on a particularly large scale during the initial ramp-up of facilities-based local providers, and certainly will not occur any sooner than the time it will take for a careful and deliberate consideration of the size and mechanisms of universal service funding. Indeed, the incumbent LECs' "scare tactics" must be seen as both transparent and disingenuous: Their real purpose is to protect their incumbency for as long as possible; the professed concerns with universal service are merely a device to that end. The numerous implicit sources of revenues that incumbents enjoy, combined with the various existing explicit sources of USF support, are not in imminent jeopardy. Therefore, policy makers can move forward in a timely but comprehensive manner to resolve the funding issues while still achieving the goals of promoting universal service and competition in the local market.

1.2 General overview of the status of regulatory USF proceedings

While the Act put a definitive stamp of approval on the public policy of competition in local exchange service, it followed, rather than led, the trend toward authorizing local competition and addressing the many important policy issues that attend that decision. Many states have included universal service as a priority issue, either within the context of a broad-spectrum competition docket or in a proceeding focused specifically on universal service.[16] The findings of state PUCs in those proceedings (although in some cases still preliminary) can contribute useful analytical inputs to aid the Joint Board's understanding of universal service requirements and funding approaches, even though they may not be entirely consistent with the framework contemplated by the Act.

Concurrent with the state proceedings, the FCC has also been actively involved in reviewing methods of making universal service funding more efficient, more precisely targeted, and more consistent with competitive objectives. The Commission had completed the NOI phase of the High Cost Proceeding, CC Docket 80-286, and had made considerable headway in the NPRM phase of that docket (with both comments and reply comments filed) by the time the 1996 federal legislation was signed. Although the legislative history of the Act suggests that CC Docket No. 80-286 should not become the sole foundation for designing support mechanisms for universal service, the Commission has properly recognized that the record in that proceeding is highly relevant to the issue of support for rural, insular and high-cost areas, and need not be recreated from scratch. The Commission has singled out as worthy of further consideration the use of a cost proxy model (and, in particular, the BCM) for implementing support to rural, insular, and high cost areas. (Obviously, there are additional related issues that need to be considered within the framework of the Act, but they are compatible with those portions of CC Docket No. 80-286 that the Commission has incorporated by reference.)

The BCM is still an evolving tool, and the Joint Sponsors have indicated that they expect to issue a new release of the model in the July 1996 time frame.[17] As the Commission suggests in its NPRM, there are a number of areas in the model that could be improved, and these aspects range from minor fine tuning of assumptions to more fundamental conceptual adjustments. In this report, we examine certain modifications and corrections that are required both to correct certain deficiencies in the BCM as well as to focus it more directly at determining the specific cost of providing universal service. We note, in this regard, that the adaptability of the cost proxy approach should be viewed as a strength, not a weakness.

1.3 Organization of this report

This report is organized as follows:

* Chapter 1 discusses the role of the Benchmark Cost Model in addressing universal service funding requirements.

* Chapter 2 discusses the essential attributes of a reliable cost proxy model, and the relationship of the Telecommunications Act of 1996 to these attributes.

* Chapter 3 describes the Benchmark Cost Model in detail, and provides an overview of ETI's approach to evaluating the strengths and weaknesses of the model.

* Chapter 4 analyzes the BCM's assumptions about (1) the cost factor for translating investments into monthly costs that reflect a return on investment and relevant expenses, and (2) the price threshold against which costs are compared for the purpose of determining the need for universal service support.

* Chapter 5 develops corrected switch cost data for the BCM, and analyzes the implications of ETI's run of the model with the corrected data for this key variable.

* Chapter 6 analyzes the BCM's implicit and explicit assumptions about the outside plant that is necessary for providing universal service, and discusses the results of ETI's run that, where feasible, partially corrects outside plant variables and algorithms in the BCM to more accurately reflect the specific universal service goal.

* Chapter 7 discusses various approaches to determining the type of threshold that policy makers should use for establishing universal service support requirements, and also examines the multiple sources of revenues that should be considered as policy makers assess the need for and size of a universal service fund.

* Chapter 8 combines the results of our corrections and analyses in the preceding chapters in order to provide an upper bound estimate of the cost of basic residence local exchange service, and an upper bound estimate of the need for universal service support.

* Chapter 9 discusses state universal service proceedings and, in particular, provides details of the investigation of cost models that is now underway in California.

* Chapter 10 summarizes ETI's major recommendations regarding how the BCM should be appropriately used in universal service policy proceedings.

Clarifying some terminology may be helpful at the outset. As a general matter, the Telecommunications Act distinguishes among (and establishes varying levels of obligations and requirements for) (1) incumbent local exchange carriers, (2) local exchange carriers, and (3) telecommunications carriers, with the first group being a subset of the latter two categories, and the second group being a subset of the third.[18] Differing duties, obligations, and rights apply to these three categories of telecommunications service providers: For example, incumbent local exchange carriers must, among other things, provide unbundled access to network elements;[19] all local exchange carriers must, among other things, provide dialing parity;[20] and "[a]ll providers of telecommunications services should make an equitable and nondiscriminatory contribution to the preservation and advancement of universal service."[21] As defined by the Act, the term telecommunications carrier "means any provider of telecommunications services, except that such term does not include aggregators of telecommunications services."[22]

In this report, the use of the terms "local exchange carrier," "incumbent local exchange carrier" and "telecommunications carrier" is intended to conform with the definitions set forth in the Act. A competitive local exchange carrier (CLEC) is not defined in the Act, but in this report the term refers to those local exchange carriers that are not incumbent local exchange carriers.

[2]Telecommunications Act of 1996, Pub. L. No. 104-104, 110 Stat. 56 (1996) ("Telecommunications Act").

[3]Id., Sec. 254.

[4]MCI Communications Inc., NYNEX Corporation, Sprint/United Management Co., and US West, Inc., Benchmark Costing Model: A Joint Submission, Copyright 1995, CC Docket No. 80-286 (Dec. 1, 1995) ("Joint Submission"). Data for Alaska are unavailable. The Joint Submission, filed December 1, 1995, did not include an updated version of the model. Therefore the model that has been submitted to the FCC and that has been made publicly available was the one current as of September 12, 1995.

[5]CC Docket No. 80-286, NPRM and NOI, op cit., footnote 1.

[6]In New York, MCI submitted BCM results to the New York Public Service Commission in order to show, among other things, that New York Telephone Company's residential customers do not need a subsidy. New York PSC Case No. 94-C-0095, Proceeding on Motion of the Commission to Examine Issues Related to the Continuing Provision of Universal Service and to Develop a Regulatory Framework for the Transition to Competition in the Local Exchange Market, letter from Richard C. Fipphen, December 18, 1995. A universal service proceeding in Pennsylvania has also encompassed consideration of the BCM. Pennsylvania PUC, Docket No. I-00940035, In Re Formal Investigation to Examine and Establish Updated Universal Service Principles and Policies for Telecommunications Services in the Commonwealth ("Pennsylvania PUC, Universal Service Proceeding"), Direct Testimony of Dr. Robert Mercer, December 7, 1995 and Rebuttal Testimony of David Townsend, February 14, 1996. See also Pennsylvania PUC, Universal Service Proceeding, Interlocutory Order, Initiation of Oral Hearings Phase, Notice of Proposed Rulemaking to Establish a Universal Service Funding Mechanism, August 30, 1995.

[7]California PUC, Consolidated R.95-01-020 and I.95-01-021, Rulemaking and Investigation on the Commission's Own Motion into Universal Service and to Comply with the Mandates of Assembly Bill 3643 ("California PUC, Universal Service Proceeding"). See Chapter 9, below for a more detailed discussion of this proceeding.

[8]"CBGs" are Census Block Groups, a demographic unit developed by the U.S. Census Bureau and used in the BCM. See Chapter 3 for a more detailed discussion of CBGs.

[9]Although the Joint Sponsors indicate that business lines are not reflected, as is discussed in Chapters 3, 5, and 6, the BCM does partially reflect the presence of businesses.

[10]Joint Submission, September 12, 1995, at 2-3.

[11]Under rate of return regulation (RORR), LECs were confronted with strong financial incentives to overinvest in their capital asset base, because (a) they were largely insulated from financial and business risks by the regulatory process itself, and (b) aggregate earnings were themselves a function of aggregate net investment. See Averch, Harvey and Johnson, Leland, "Behavior of the Firm under Regulatory Constraint," American Economic Review, Volume 52, No. 5, 1962, at 1053-1069. One of the often articulated goals of "incentive regulation" was to reduce or to eliminate altogether this so-called "A-J Effect" by severing the link between revenues and costs. California PUC, Consolidated Dockets Nos. I.87-11-033 et. al and A.87-01-002, Re Alternative Regulatory Frameworks for Local Exchange Carriers, Decision 89-10-031, October 12, 1989, 33 CPUC 2d 43, at 44; and In the Matter of Policy and Rules Concerning Rates for Dominant Carriers, CC Docket No. 87-313, Second Report and Order, October 4, 1990, at 15. Since the future will be characterized by regulatory mechanisms in which the historic overcapitalization incentive is minimized (or perhaps eliminated altogether by the onset of competition), reliance upon embedded costs introduces a serious distortion and exaggeration of the forward-looking costs of providing universal service.

[12]Throughout this report, the focus is on that aspect of universal service related to the provision of basic local exchange service to the household. Congress has also established a goal of deploying advanced telecommunications and information technology to schools, libraries, and hospitals. Telecommunications Act, see Sec. 254(h). It is not the intent of this report to address these important additional commitments reflected in the Telecommunications Act.

[13]Joint Submission, at 1.

[14]See Section 2, below, for a more detailed discussion of the way in which any particular cost proxy model should be evaluated.

[15]Tennessee PSC, Docket No. 95-02499, Universal Service Proceeding ("Tennessee PSC, Universal Service Proceeding"), Testimony of Peter F. Martin (BellSouth), October 20, 1995, at 13; Massachusetts D.P.U. 94-185, Local Exchange Competition Proceeding, Direct Testimony of Paula Brown, May 19, 1995, at 23-24.

[16]See e.g., Florida PSC, Docket No. 950696-TP, Determination of funding for universal service and carrier of last resort responsibilities, Order No. PSC-95-1592-FOF-TP, December 27, 1995; Pennsylvania PUC, Universal Service Proceeding, op cit., footnote 6.

[17]See, e.g., California PUC, Universal Service Proceeding, AT&T's Response to Pacific Bell's Data Request, filed March 11, 1996, at 18.

[18]Telecommunications Act, Sec. 3(a)(2)(44); Sec. 3(a)(2)(49); Sec. 251(h).

[19]Id., Sec. 251(c)(3).

[20]Id., Sec. 251(b)(3).

[21]Id.,, Sec. 254(b)(4).

[22]Id., Sec. 3(a)(2)(49).