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In Re RATE REDUCTION FOR INTERSTATE LONG-DISTANCE TELEPHONE CALLS

FEDERAL COMMUNICATIONS COMMISSION

21 F.C.C.2d 654 (1969)

RELEASE-NUMBER: FCC 69-1210

November 5, 1969

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The Commission, by Commissioners Burch, Chairman; Bartley, Robert E. Lee, Cox, and H. Rex Lee, with Commissioner Johnson dissenting and issuing a statement, approved the following public notice.

[*654] RATES FOR INTERSTATE LONG-DISTANCE CALLS TO BE REDUCED

Reductions in rates for interstate long-distance telephone calls will be submitted shortly by the Bell System telephone companies to the Federal Communications Commission. It is expected that the reduced rates will save users of telephone service about $150 million per year. In addition, A.T. & T. has previously agreed to file reductions of about $87 million representing an offset to increases in revenues resulting from higher rates recently filed for program transmission, Telpak and teletypewriter exchange (TWX) services when the latter increases become effective. The Commission anticipates that the new rates will permit the companies to achieve earnings in a range needed to attract capital under today's conditions.

The proposed reductions are being submitted by A.T. & T. in connection with the comprehensive review recently completed by the FCC of the Bell System's interstate operations and earnings requirements. The review was conducted as part of the Commission's continuing surveillance of the Bell System's interstate operations, and was participated in by representatives of the Commission's staff, Bell System officials, and several outside consultants who are expert in economics and finance.

The proposed rate reductions take account of the material increases in A.T. & T.'s cost of capital. At the same time, they recognize that the growth in interstate traffic is continuing unabated; that the average revenue per message has shown steady increase since the reductions required by our 1967 decision took place; and that the interstate earnings of the company have consistently grown despite the increases in its costs due to the inflationary spiral. In 1969, interstate earnings are expected to exceed 8 percent. We fully expect that the growth trends in traffic, revenues, and earnings will continue. This expectation is substantiated by A.T. & T.'s own forecast of interstate operating results for 1970, which ranges, under present rates, to levels above 8.5 percent, depending on economic conditions. Consistent with experience following [*655] prior rate reductions, we also anticipate that the interstate revenues and earnings will be stimulated to some extent by the reductions in rates the company is now proposing. Thus, it is anticipated that the rate adjustments announced today will not, in themselves, prevent the company from achieving earnings in the aforementioned range. The Commission will maintain a continuing surveillance and take such action as is appropriate in the light of future conditions.

The Commission initiated the current review in light of the sustained growth in the interstate earnings of the Bell System to levels well in excess of the level determined by the Commission to be adequate and reasonable in its 1967 decisions. In conducting the current review, the Commission examined the company's present and anticipated capital needs and the levels of, and trends in, its revenues, expenses and earnings. The Commission focused on A.T. & T.'s cost, under current economic conditions, of attracting the large amounts of new capital, estimated at more than $200 million a month, required by A.T. & T. for its ever-increasing construction program to meet new and expanding needs of the public for communication services.

The examination was made by the Commission within the framework of the principles and standards it formulated in its decisions issued in July and September 1967, following a comprehensive formal investigation and hearing into the Bell System's interstate rates (docket 16258). In those decisions, the Commission concluded, among other things, that a return in the range of 7 to 7.5 percent was fair and reasonable at that time for purposes of effecting adjustments in A.T. & T.'s interstate rates. It also stated that it did not regard this range as establishing an absolute floor or ceiling for future earnings. Instead, it said it would, when there were departures from this range, consider the matter in light of conditions obtaining at that time.

In keeping with those principles, the Commission is of the view, in the light of current conditions, and with due regard to the proposed reductions, that interstate rates producing an earnings level which exceeds the upper limit of the 1967 range (7.5 percent), are not unreasonable. The Commission based this view on the changes which have taken place since 1967 in the economic, financial, and other conditions that affect A.T. & T.'s revenue requirements and its ability to attract new capital. The Commission noted particularly the sharp increase in the interest rates on borrowed capital, the resulting increase in the company's cost of embedded debt, the much higher rate of inflation today, and the need to raise substantial amounts of new capital under current market conditions. These factors constitute substantial changes from the conditions which prevailed at the time of the 1967 decisions and must be reflected in a current assessment of the company's cost of capital and revenue requirements.

There are also a number of uncertainties in the current situation and in the national economic outlook. These include the persistent inflationary trend, with its effects on the cost of capital; the effectiveness of the Government's efforts and policies to curb this trend and stabilize prices; the possible effects of such efforts on the continued growth of the economy; and the duration of any period of adjustment. Another uncertainty results from the present status of the Federal corporate [*656] income tax and surcharge, as well as the potential changes resulting from the reform provisions of the pending tax legislation.

In view of these uncertainties, the Commission wishes to make clear that the views expressed herein relate to the current situation and cannot be binding under any future changed economic conditions.

The Commission notes that technical changes in separations methods which it recently accepted at the request of the NARUC result in a $35 million transfer of revenue requirements, to the benefit of users of local services subject to State regulatory jurisdiction.

The details of the rate changes are being worked out by the company. The new rates will be submitted to the FCC in revised tariffs which will become effective on statutory notice.

Action by the Commission November 5, 1969. Commissioners Burch (Chairman), Bartley, Robert E. Lee, Cox, and H. Rex Lee, with Commissioner Johnson dissenting and issuing a statement (attached).

Continuous Surveillance

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SEPARATE STATEMENT OF COMMISSIONER NICHOLAS JOHNSON

I. INTRODUCTION

The Commission today offers for public view the results of its recent informal negotiations with the Bell System on the appropriate level of interstate rates. The effectiveness of the Commission in this area and the suitability of continuous surveillance as a regulatory technique can now be evaluated. My analysis indicates that the technique is rather ineffective and that the Commission's adherence to announced principles is sharply limited when it comes into conflict with A.T. & T. The Commission here issues a press release designed to show that significant decreases have voluntarily been agreed to by Bell. The implication is that some wonderful victory has been achieved for the consumer through the activities of the Commission and the benevolence of A.T. & T. Unanswered is the question of whether enough has been achieved or whether the Commission's representation is a true reflection of the facts.

II. CONTINUOUS SURVEILLANCE AS A REGULATORY TECHNIQUE

Continuous surveillance is a regular informal review of particular regulatory issues -- in this case A.T. & T.'s interstate rate of return. Informal closed door negotiations were held with Bell to examine going levels of earnings with a view to possible appropriate action by the Commission or Bell. The theory is that in the context of these negotiations the Commission will be able to make an informed judgment as to what action would serve the interests of the public as consumers and that Bell would agree to take that action even though it is harmful to the interests of its stockholders. Initially there seems no reason that a regulated company would agree to actions inimical to the interests of its stockholders. However, a company may in fact be willing to meet certain levels of public responsibility which are not too harmful in terms of stockholder reaction.

[*657] The Commission has certain penalties it can impose if a company is unresponsive. A company does not wish to receive the unfavorable publicity generated by public Commission criticism of a failure to respond to the interests of the consumer. (Thus, not only has the Commission negotiated with Bell on the rate reduction; the content of the FCC majority's press release was negotiated with Bell officials who are clearly concerned as much with publicity as with profits.) The Commission could issue a show cause order to require a recalcitrant company to prove why its rates should not be lowered. Finally, there is the threat of a full-scale investigation with its attendant uncertainty and unfavorable publicity. The Commission is not without weapons to compel action by the regulated company -- even though the continuous surveillance proceeding is not a formal hearing from which orders may be issued.

There are severe limits to the Commission's ability to function in this type of a proceeding. Virtually all of the information was selected, packaged and presented by Bell -- there was no direct case from our staff or outside representatives. There was no leavening from outside consumer representatives -- even though the New York City Consumers Affairs Department requested (and was denied) the opportunity to appear. The negotiating process depends on the skill and dedication of the negotiators -- and a company with a single position faces a multi-member Commission with a variety of positions. There are no limits on the lobbying efforts by the company -- to staff or Commissioners -- since ex parte rules do not apply. Whatever decisions are made -- whether adjustments are needed, how much, what the company agrees to and how much the Commission compromises -- are not normally explained publicly in the way formal decisions are. Public statements are made long after the decisions in fact have been made. Appeal from decisions is difficult -- there is no opportunity to seek reconsideration of a formal Commission decision or appeal it to the courts. There are no parties to appeal. Apparently all that can be done is to petition for rejection of whatever revised tariffs Bell decides to file as a result of the negotiations.

III. CONSUMER ADVOCATES

In response to some of the inherent problems with the continuous surveillance proceeding the Commission in this instance decided to denominate two staff members to ask questions of the A.T. & T. witnesses from the consumer's point of view.

Operating in a capacity separated from that of the Commission's Common Carrier Bureau staff, these staff members conducted their own cross-examination of Bell's witnesses and offered some additional materials relating to their examination. The quality and completeness of the information before the Commission was improved by their performance. Bell's discomfiture was obvious. On balance, the continuous surveillance process was clearly improved by this limited use of denominated consumer representatives.

The innovation did, however, heighten the tension as to the role of the Commission's staff in rate proceedings. The Commission has traditionally viewed its staff in ratemaking proceedings as combined protector-of-the-consumer [*658] and neutral adviser-to-the-Commission. I have elsewhere argued that the combined functions necessarily affects the quality of the consumer advocacy and this was confirmed by the experiment in this proceeding. A.T. & T., 9 F.C.C. 2d 30, 122 at 141 (1967). I believe the Commission ought to use staff consumer advocates in all important ratemaking matters. The Commission ought to do all it can to have forceful advocacy for alternatives presented to it -- a necessary ingredient for competent choice in any decisionmaking process.

IV. RESULTS REACHED AND ACHIEVED

Bell argued it should be allowed to earn 8.5 to 9 percent on its total allowed rate base -- and thus that the Commission should modify de facto its 1967 decision that the appropriate Bell rate of return was 7 to 7.5 percent. (Testimony of Mr. D. E. Emerson, vice-president, A.T. & T., submitted Aug. 8, 1969.) This 2-percent range from 7 to 9 percent for interstate operations alone, could cost consumers as much as $500 million more per year depending on the level fixed by the Commission. (A change of 0.1 percent in Bell's rate of return has a $24 million effect on the amount of gross revenues the consumer must pay for interstate services. The FCC only regulates interstate rates, which constitute about one-third of A.T. & T.'s total income. Fifty States and the District of Columbia regulate A.T. & T.'s revenues from local service. Thus, the total consumer impact of a $500 million interstate range, if duplicated in local rates as well, would be $1.5 billion. In point of fact, A.T. & T. will in all probability use the majority's decision to urge higher rates from the States. In any event, $1.5 billion is quite a slush fund to be affected by where one puts the decimal point in a 2-percent range. It illustrates the enormity of A.T. & T., the difficulties in its regulation, and the significance of the FCC's decision.)

After this recent continuous surveillance session with A.T. & T. representatives the majority concluded that Bell's current going rate of return is 8.25 percent, that 7.4 percent was appropriate for purposes of negotiation, and a $200 million rate decrease (after adjusting for stimulation effects) was warranted. To reduce 8.25 to 7.4 percent, at $24 million for every 0.1 percent requires 0.85 times $24 million, or $204 million. To this sum was added the $90 million in MTT (message toll telephone) rates Bell had agreed to file as a result of price increases made in non-MTT (Telpak, TWX, Program Transmission) services. ( A.T. & T. Co., 18 F.C.C. 2d 761 (1969).) Thus, the majority was seeking reductions of $290 million through negotiations conducted by the FCC staff and the Telephone Committee (Commissioners Hyde, Bartley, and Cox) with A.T. & T. executives.

Bell now says they have agreed to reduce rates by $240 million. The majority's compromise in negotiations will cost the consumer $50 million per year. The majority first sought $200 million in reduction plus the $85 to 90 million MTT reductions as offsets to the other rate increases Bell has filed. Bell as a counter offer suggested $120 million plus the offsets. Bell also wanted a public statement from the Commission that a return of 8 percent was justified. The majority commendably refused, initially, in view of the fact the Commission is [*659] committed in its on-the-record hearing and decision of 1967 to a rate of return for A.T. & T. in the range of 7 to 7.5 percent. Now, unfortunately, the joint FCC-A.T. & T. press release says that a rate above 7.5 percent is justified, and that earnings in the range of 8 to 8.5 percent will result from its decision. It is, in any event, indisputably clear that the Commission today sanctions a rate of return in excess of 7 1/2 percent -- the maximum permitted under its own prior order!

Bell offered to reduce MTT rates by $240 million -- with a favorable press release. The majority accepted. The majority's compromise appears to cost the consumer $50 million per year. In fact the majority's additional compromise from what it should have sought from Bell may cost the consumer $250 million per year!

The majority's decision to seek only $290 million in reductions, in the face of Bell's present level of earnings, severely harms the consumer and is a strong critique of the continuous surveillance process. Let us assume for the moment that the majority's 7.4 percent goal for Bell's rate of return was correct. Would $290 million in reductions have reached this level? We can be almost certain that it would not. One need only examine the history of continuous surveillance as well as the results of the 1967 rate proceeding. Having ordered, and planned for, a 7 to 7.5 percent rate of return, Bell's interstate rate of return has not only never fallen below 7 percent, it has not even fallen below 7.5 percent since 1961! (The rates of return have been: 1961 -- 7.72 percent; 1962 -- 7.55 percent; 1963 -- 7.51 percent; 1964 -- 7.99 percent; 1965 -- 7.95 percent; 1966 -- 8.29 percent; 1967 -- 8.25 percent; 1968 -- 7.60 percent.) Although rate reductions were occasionally achieved during this period, it is not at all clear that they were enough. Bell appears to have been successful in earning extra profits through the ineffectiveness of the continuous surveillance process. These profits may have been the cause for the significant over-valuation of Bell's stock during this period and its subsequent readjustment.

The rate of return for 1968 is particularly significant. After a formal rate proceeding the Commission ordered Bell to file tariffs to reach an allowed rate of return of 7 to 7.5 percent. The effect of $20 million in a $120-million rate reduction order was deferred for a substantial period in 1968 out of the professed fear that earnings might fall below the 7 percent level. ( A.T. & T., 12 F.C.C. 2d 167, 168 (1968).) The Commission's fears for Bell's financial health were misplaced. Not only did bell not go below the lower end of the range, it exceeded the higher limit, earning 7.6 percent. As if this were not enough, only the Vietnam war and its attendant surtax saved the Commission from further embarrassment. Without the surtax Bell would have earned in the range of 8.2 percent -- a full 0.7 to 1.2 percent above the range supposedly established by the Commission's 1967 decision. The record suggests that Commission decisions systematically err in Bell's favor on rate of return matters.

An examination of today's decision suggests some of the reasons for the FCC's errors. No estimate is made for growth in Bell's 1970 earnings, although Bell has enjoyed steady growth. No estimate is made for possible lower unit costs, although Bell proudly reports [*660] its cost-reducing achievements. No account is taken of the effects of relaxation of the income tax surcharge. If the surcharge rate is reduced to 5 percent on January 1, 1970, then $70 million less gross revenues will be needed to reach 7.4 percent. By June 30, 1970, when the remaining 5 percent is scheduled to be lifted, another $70 million less in gross revenues will be needed by Bell. Since the surveillance process generally takes at least a year from the time excess earnings occur, to Commission recognition, to Commission action, to tariff filing, the majority's failure to take account of the probable effects of the surcharge changes may cost the consumer $100 million in 1970. (The majority could have directed Bell to have tariff reductions in hand ready for filing when the surtax changes come. It expressly declined to do so. Why? For this discussion it is recognized that Bell has effectively passed the entire surtax on to its consumers.)

The majority's willingness to settle for $240 million in reductions can also be attacked for its de facto modification without hearing of the Commission's 1967 order. The Commission rejected the participation of outside parties representing consumer interests but did allow attendance by representatives from NARUC (the association of State regulatory commissioners). The majority has made a decision in fact, but there is no announcement of it (only a press release indicating that Bell will be filing reduced tariffs), no rationale offered for it, and no consideration of the rights of parties who may feel aggrieved. A leading case is often cited for the proposition that no legal redress is available for decisions reached under continuous surveillance. ( The Public Utilities Commission of the State of California v. United States, 356 F. 2d 236 (9th Cir. 1966).) However, the fact that the Commission recently made an on-the-record determination, and now changes it without hearing, may present a different legal situation.

Bell argued that circumstances had changed from the 1967 environment, and that these changes warranted a change in their allowed rate of return. Its evidence focused on one basic point -- the change in the interest rate for long-term debt capital. The majority agreed with Bell to the turn of $100 million per year. (The difference between a range of 7 to 7.5 percent and 7.4 to 7.9 percent is between $24 million and $196 million.) In 1967 the Commission reached two basic conclusions -- the overall rate of return should be 7 to 7.5 percent and Bell had been severely negligent in not using more debt financing in the past, a policy that has, and continues, to produce unnecessarily high prices for the consumer and unnecessarily low earnings for the shareholder.

The issues concerning proper capital financing of a public utility need not be as confusing as one might assume. A company can raise capital by equity (stock) or by debt (borrowing). Equity includes retained earnings (those not paid out in dividends) and money gained from stock sales. Debt is capital borrowed from money lenders at a fixed rate of interest (usually long-term bonds). Other things being equal, debt financing is generally much less costly to the consumer and much more beneficial to the stockholder. Debt costs less for two basic reasons. The interest rate is normally much lower than the return required for equity.

Moreover, interests costs on debt are a cost [*661] of doing business and as such are decucted before the payment of corporate income taxes. The corporation must pay taxes on the revenue used to pay dividends to shareholders. The pool of earnings available to stockholders is made up of the difference between the average cost of debt (now 5 percent for A.T. & T.), and the authorized rate of return (formerly 7 to 7.5 percent). The larger the share of debt the greater that pool of earnings, the fewer stockholders who must share it, and the higher the dividends.

Since the 1967 decision Bell has acknowledged its past errors (although it refuses to make up for the penalties paid by consumers and shareholders who have suffered), and has now gone to all-debt financing. It has, of course, missed out on decades of 3 and 4 percent money and must now pay some of the highest rates for debt in our Nation's history. Even at the present high interest rates, however, debt financing continues to exert a favorable leveraging effect on Bell's earnings -- for debt, however expensive, is almost always cheaper than equity. In fact, as the staff consumer representatives pointed out in a chart submitted during cross-examination, Bell has been able to offset the effects of high interest rates through the increased leverage of greater quantities of debt.

1966 (test year) allowed rate or return 7 to 7 1/2 percent

Of all capital investment --	The proportion of total rate of return allocated to each would be --
	Low	High
31.5 percent (was) debt at (an average cost of) 4 percent interest
	1,26	1.26
68.5 percent (was) equity (on which the FCC was permitting an) 8.4 to 9.1 percent return.
	.74	6.24
Total allowed rate of return	7.00	7.50

1969 Calculation Incorporating. -- (1) Higher interest rates being paid; (2) Changed capital structure; (3) The same return on equity range as allowed in the 1967 decision.

Of all capital investment --	The proportion of total rate of return allocated to each would be --
	Low	High
40 Percent (was) debt at (an average cost of) 5 percent interest
	2.00	2.00
60 percent (was) equity (on which the FCC was permitting an) 8.4 to 9.1 percent return
	5.04	5.46
Total allowed rate of return	7.04	7.46

NOTE. -- The increased interest cost for debt (the average cost for all debt increased from 4 percent in 1966 to 5 percent in 1969) is counteracted by the increase in debt ratio (31.5 percent of all capital was debt in 1966; 40 percent was debt by 1969) so that if the return on equity remains the same, the allowed rate of return would remain the same.

The majority's calculation is perhaps simpler. In 1967 the Commission said the Bell System could be earning at least 9 percent on equity if it had achieved a debt ratio of 40 percent at 4-percent embedded interest cost, although Bell had debt ratio of about 35 percent [*662] at the time. (A debt ratio is the ratio of the amount of debt to the total capital of a company -- a company with $100,000 total capital of which $35,000 is debt has a 35-percent "debt ratio." "Embedded interest cost" is the average interest rate being paid on debt capital of the company.)

If Bell had a 40-percent debt ratio and was paying on the average of 4 percent in interest, a 7 percent overall return on capital would result in a 9 percent return to equity.

	Percent
40 percent debt times 4 percent interest	1.6
60 percent equity times 9 percent return	5.4
Total return	7.0

At 7.5-percent return Bell would be earning 9.83 percent on equity.

	Percent
40 Percent debt times 4 percent interest	1.6
60 percent equity times 9.83 percent return	5.9
Total return	7.5

Today Bell has a 40-percent debt ratio but borrowing at higher interest rates has made its average interest cost for all debt capital 5 percent. In order to achieve a 9-percent return on equity, the overall rate of return must be set at 7.4 percent, the majority's original figure.

	Percent
40 percent debt times 5 percent interest	2.0
60 percent equity times 9 percent return	5.4
Total return	7.4

The crucial question is whether the 1967 decision guaranteed Bell a 9-percent return on equity. There is a strong suggestion it did not. As noted, a 7 to 7.5 percent rate of return suggested a return on equity based on 1966 test year data of 8.4 to 9.1 percent. The leveraging effect of all-debt financing has retained that range of equity return even if there is no change in the allowed range of 7 to 7.5 percent on total capital. And there was no demonstration by A.T. & T. that the fundamental factors affecting the required return on equity have caused the cost of equity capital to A.T. & T. to increase.

The majority easily could have taken account of the surtax and reduced the going rate of return to 7 percent. It could have made some estimate of the impact on rate of return in 1970 from growth and lower cost technology. It did not. Cost to the consumer: At least $200 million a year.

V. CONCLUSION

There are a number of concluding comments which seem relevant.

Consumers, and Bell's shareholders, continue to suffer from Bell's past errors in financing. Bell abhorred debt financing in periods of low-interest rates. It thus finds it necessary to use debt at a time of very high interest rates. But it is even more disquieting that Bell now speaks of returning to equity in the form of convertible bonds -- despite the fact that debt financing continues to be less costly to the consumer and more beneficial to the stockholder than equity financing. Moreover, Bell's debt ratio, although increasing, is still not within [*663] shouting distance of that employed by most other major telephone, electric, and gas utilities. Today Bell's consumers must still pay a higher rate of return on total capital than they pay electric utilities; Bell's stockholders still get a lower return on equity from Bell than they obtain from the electrics. Moreover, these relationships are likely to prevail for some time in the future as Bell attempts to extricate itself from its past inefficient financing policies. It is of some concern that the Commission majority says nothing on this issue -- as it remained silent when Bell followed costly equity financing in the past -- even after it has concluded that Bell is less risky than the electrics. If Bell elects to improve its capital structure at its leisure, must the consumer pay for today's inefficient financing as well as yesterday's?

Bell continues to refuse to use liberalized depreciation schedules available to it. The majority refuses to deal with this issue, despite the fact that liberalized depreciation could in the past, and would now, provide substantial benefits both to consumers and to stockholders. (See the discussion in Trebing (ed), Rate of Return Under Regulation, pp. 129-175 (1969).) Bell and FCC errors as to liberalized depreciation are likely of the same order of magnitude as their errors in capital financing -- with comparable adverse impact on consumer and stockholder alike.

The Commission implicitly allows Bell to pass on to consumers the full amount of the Vietnam surtax for the purpose of rate level calculations. A strong case can be made that Bell should bear at least some of the costs of this special war-inflation tax. The Commission said in a letter to then Consumer Affairs Assistant Betty Furness in 1968 that it would at least consider that possibility.

Bell and the FCC use electric utilities for comparison purposes. Several comments are relevant. Implicit is the assumption that the regulation of the electrics has achieved a proper rate of return and thus the performance of the electrics is a proper benchmark. Some might disagree. Senator Lee Metcalf and Vic Reinemer in their book "Overcharge," urges that electric utilities -- the FCC's comparative standard -- are in fact earning too much. (Metcalf and Reinemer, "Overcharge" (1967).) Even if that were not the case, the electrics still require far less in overall rate of return from the consumers (6.7 percent in 1968 for the electrics to Bell's 7.6 percent) while returning far more to their shareholders (11.9 percent in 1968 for the electrics to Bell's 9.3 percent). How can such disparity be tolerated or explained? By what conceivable rationale is such mismanagement to be rewarded? Aren't the American people entitled to know that they will be paying almost $500 million a year more for telephone service than might have been necessary?

Bell's contempt for the consumer is clear. Not only does it refuse to lower exorbitant rates. It demonstrates a shocking acquiescence in the decline in the quality of telephone service. And then it points to this slipshod performance as reason to reward it with higher profits. Jules Feiffer has concisely portrayed the attitude.

It is difficult to evaluate the process of continuous surveillance as a regulatory tool. It offers some real procedural benefits. But it requires somewhat more than the Commission was able to bring to it this time.

[*664] [SEE GRAPHIC IN ORIGINAL]

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