1. Methods of Regulation Rate of return Incentive systems –Rate freeze –Rate bands or ranges –Price Caps

2. Uses of Rate of Return Method For regulatory commissions –At the state level, used as the basis for rate cases: carriers’ requests for a rate increase –At the interstate level, used as the basis for ratemaking for interstate toll and for access charges Within the Bell system –Used as basis for division of revenues

3. Flow of information Keep chart of accounts according to Part 32 For Interstate, do ROR for AT&T “toll pot”/ later for access charges For Intrastate, do ROR for state commission Do Jurisdictional Separation

4. Rate of Return Regulation “Cost Plus” regulatory method that covers a carrier’s “revenue requirement” Revenue Requirement: the amount of revenue the carrier requires to cover expenses and provide the “allowed return” on “rate base” Rate Base: the carrier’s investment in plant and facilities Allowed Return: the percentage of earnings approved by the regulator

5. Issues of concern How to determine the rate base? –Valuation method, “used and useful” What are allowable expenses? How to determine an allowed return? –Cost of Capital method—firm’s capital structure Market-determined standard versus comparable earnings standard

6. Revenue Requirement Example Assume Telco has –$3 million in expenses –Rate base of $50 million –Allowed return of 10% Telco’s revenue requirement is calculated: –RR = $3 million + (10% x $50 million) = $3 million + $5 million = $8 million

7. Use of Revenue Requirement Carriers can set their rates so that the revenue requirement is realized For example: –Assume Telco provides local service and state toll –Assume Telco’s local rates are $10 per month and their long distance rates are $.15 per minute –Assume Telco has 50,000 local lines and that callers made 5 million calls

8. Use of Rev Reqt continued Telco has billed: –Local service of 50,000 x $10 x 12 months = $6 million –Toll service of 5 million calls x $.15 = $750,000 Telco has a short fall of $1,250,000 –Revenue Requirement of $8 million –Billings of only $6,750,000 Telco can now raise its rates to generate an additional $1,250,000

9. The traditional approach To get $1,250,000 from local would have to raise local rates by about $2.08 (to $12.08) 50,000 x 12 months x $2.08 = $1,248,000 To get $1,250,000 from toll would have to raise toll rates by $.25 (to $.40) 5 million calls x $.25 = $1,250,000 The traditional approach has been to raise the toll rates first---Why???

10. Logistical issues Determination of the allowed return Arguments about the “test year” –Historical with adjustments Arguments about what is “used and useful” Problems with “regulatory lag”

11. ROR and access charges To deal with regulatory lag, access charges were based on forecasted costs and demand Rates were set prospectively; adjustments were made after the fact

12. The basic approach A = Forecasted rate base B = Forecasted expenses C = Allowed rate of return D = Forecasted demand Forecasted RRQ = B + (A x C) Price = RRQ/D

13. An example Telco forecasts the following –Rate base of $200 million –Expenses of $30 million –Allowed return of 10% –Demand of 100 million minutes So, –Forecasted RRQ = $30 M + (10% x $200 M)= $50 M –Price = $50 Million/100 million minutes = $.50

14. True-up after the fact Assume Telco’s actuals were: –Rate base of $190 Million –Expenses of $35 Million –Demand of 110 million minutes Then, –Actual revenue was 110M minutes x $.50 = $55M –Actual earnings were ($55M-$35M)/$190M= 10.5% –Telco over-earned

15. Problems with the ROR method? Leads to “gold plating” Lack of incentive to be efficient Lack of incentive to be innovative

16. Price Caps Regulate price movement, instead of cost Attempt to control cross subsidization by creating baskets of services –Regulate how prices move within a basket In theory, was to create incentive to be innovative and efficient by not controlling earnings –Did continue to monitor earnings, however –Created a sharing mechanism

17. Price Cap Approach Use of Indexing What are indexes and how do they work? Example: Consumer Price Index (CPI) –Market basket of consumer goods –Price monitored over a period of time

18. Consumer price index example Year 1: market basket costs $25 –Initialize the index at 100% Year 2:market basket costs $25.50 –The index is 102% from Year 1 Year 3: market basket costs $26.55 –The index is 104% from Year 2 –The index is 106.2% from Year 1

19. Price Cap Process First Step is the calculation of Price Cap Index (PCI) –PCI = an index of changes in inflation, carrier productivity and any changes beyond the carrier’s control –PCI new = PCI last yr + change in GNP-PI – productivity offset + (increase of decrease caused by cost changes)

20. PCI example Assume the following: –Last year’s PCI was 101% –The change in the Gross National Product- Producer Price Index since last year was +5% –The productivity offset is 3% –There are no pertinent cost changes PCI new = 101% + 5% - 3% = 103%

21. The next step Calculating the Actual Price Index (API) API = index of proposed prices weighted by base period demand and pricing API cannot be greater than the PCI

22. How do you calculate the API? Refer to the handout provided in class –This is just to complicated to do on a slide

23. Effects of Price Caps Expedited tariff filing period Return to historical demand data Continued reliance on cap on earnings, at least for awhile; but carriers did get to keep more of their earnings Shifted the discussion away from cost—to demand Got away from a purely cost plus approach