# Respondents Brief — Worldcom, Inc. v. Verizon Communications Inc.

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## Record

- **Collection:** Supreme Court brief
- **Document type:** Respondents Brief
- **Published:** January 1, 2002
- **Citation:** 537 U.S. 807

## Text

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Nos. 00-511, 00-555, 00-587, 00-590, 00-602
Pave te

IN THE
Supreme Court of the United States

VERIZON COMMUNICATIONS INC. ef al.
Petitioners.
V
FEDERAL COMMUNICATIONS COMMISSION AND THI

UNITED STATES OF AMERICA.
Respondents

On Writ of Certiorari
to the United States Court of Appeals
for the Eighth Circuit

RESPONDENT'S BRIEF OF AT&T CORP.

MARK C. ROSENBLUM DAVID W. CARPENTER*
LAWRENCE J. LAFARO PETER D. KEISLER
RICHARD H. RUBIN DAVID L. LAWSON
AT&T Corp STEPHEN B. KINNAIRD
295 North Maple Avenue C. FREDERICK BECKNER III
Basking Ridge, NJ 07920 SIDLEY AUSTIN BROWN &
(908) 221-8410 WoopD
1722 Eye St, NW
Washington, DC. 20006
(202) 736-8000

Counsel for Respondent

June 8, 2001 * Counsel of Record

WILSON-EPES PRINTING Co., INC. — (202) 789-0096 - WASHINGTON, D. C. 20001

BEST AVAILABLE COPY

QUESTION PRESENTED

1. Whether the court of appeals erred in holding that
neither the Takings Clause nor the Telecommunications Act
of 1996 requires incorporation of an incumbent local
exchange carrier’s “historical” costs into the rates that it may
charge new entrants for access to its network elements?

li
LIST OF PARTIES AND AFFILIATES

The parties to the proceedings in the Eighth Circuit are
listed in Appendix A and Appendix D of AT&T’s Petition for
Certiorari at 1a and 222a-224a.

Pursuant to Supreme Court Rule 29.6, respondent states as
follows: AT&T provides telecommunications, cable, and
other services. AT&T has no parent company. No publicly
held company owns more than 10 percent of AT&T’s stock.

iti
TABLE OF CONTENTS

EE

LIST OF PARTIES AND AFFILIATES .....................

TABLE OF AUTHORITIES............... ....... omens

STATERGENT OF THEE CASE ................ccccssccccsccesseeees

SUMMARY OF ARGUMENT . 000000...

SECTION 252(d)1)A) DOES NOT REQUIRE
A HISTORICAL-COST RATEMAKING

THE TAKINGS CLAUSE DOES NOT RE-
QUIRE THE 1996 ACT TO BE INTERPRETED
TO MANDATE HISTORICAL-COST RATE-

A. Even If TELRIC Required That Network Ele-
ments And Interconnections Be Provided Be-
low Historical Cost, The LECs Have Presented
No Serious Takings Claim................................

B. The Adoption Of TELRIC Would Raise No
Substantial Takings Claim Even If The Meth-
od Governed The Determination Of All Of

C. The LECs’ Claims Of A “Switch” In Method-
ologies Are Legally Meritless And Depend On
Erroneous Extrarecord Assertions.....................

17

24

26

29

33

iV

TABLE OF CONTENTS - continued
Page
1. TELRIC Is Not An Impermissible Switch
In Methodologies That “Strands” Invest-
ee ee nee 35
2. The LECs’ Regulatory Compact Claim Is
RI... scnncnanensngumstencatignandntnaieonmanetdiinass 39

Ill. THE FCC’S REJECTION OF THE LECS’
HISTORICAL-COST PROPOSALS WAS NOT
ARBITRARY AND CAPRICIOUS ...................... 41

A. All Ratemaking Methods Are Hypothetical
And There Is No Basis For The Claim That
Other Methods Would Fulfill The Act’s Objec-
tives At Lower Administrative And Other

TI... sccnnsnsetai stenieeliiamniiainacenimmietiienediats 43
B. Competitive Pricing Of Network Elements
Does Not Frustrate The Act’s Purposes ............ 48

I ceccccenesencessccccescvsssnstitinescsstsiccenstinnninatasion 50

Vv

TABLE OF AUTHORITIES
CASES Page
AT&T Corp. v. Iowa Utils. Bd., 525 U.S. 366
NE cee eee ane A ae 15, 24, 48
American Commercial Lines, Inc. v. Louisville &
Nashville R.R., 392 U.S. 571 (1968) o.oo. 41
American Paper Inst., Inc. v. American Elec.
Power Serv. Corp., 461 U.S. 402 (1983)............ 4]
B&O RR v. United States, 345 US. 146
STS eae = 6 an 15, 26
Bell Atl. Tel. Cos. v. FCC, 79 F.3d 1195 (D.C.
AE RE SRS. San oo 5
Brooks-Scanion Co. v. Railroad Comm'n, 251
ETE ATER ree: 28
Chevron, U.S.A., Inc. v. Natural Res. Def.
Council, Inc., 467 U.S. 837 (1984) 0000. 17
Consumers’ Counsel v. FERC, 914 F.2d 290
I SS Se ae 44
Duquense Light Co. v. Barasch, 488 U.S. 299
ERE SSSR Sateen eae passim
Entergy Gulf States, Inc. v. Louisiana PSC, 726
eR SRE ern care ae 44
FERC v. Pennzoil Producing Co., 439 U.S. 508
Roe RR SSSR 31
FPC v. Hope Natural Gas Co., 320 US. 591
ES a 3, 20, 22, 31
FPC v. Texaco, Inc., 417 U.S. 380 (1974)............ 15, 28

Kansas Gas & Elec. Co. v. State Corp. Comm'n,
720 P.2d 1063 (Kan. 1986), vacated in part,

481 U.S. 1044 (1987) ooo cccccccceecseeeseeesees 44
Keystone Bituminous Coal Ass'n v. DeBenedictis,

ell 41
Long Island Lighting Co. v. PSC, $23 N.Y.S.2d

615 (N.Y. App. Div. 1987) 0000... 44

Louisville Bridge Co. v. United States, 242 US.
gat Ee a 41

vi
TABLE OF AUTHORITIES - continued

Page
Market St. Ry. v. Railroad Comm'n, 324 U.S. 548
Tisha scctinieisiieaineamntiionnaiheguatinnetinnaitemineeeian 31
Mobil Oil Exploration & Producing S.E., Inc. v.
United Distribution Cos., 498 US. 211
BR EERE eS EES TREE | ADS re 21, 32, 40
Munn v. Illinois, 94 U.S. 113 (1876)..................... 39

National Ass'n of Greeting Card Publishers v.
United States Postal Serv., 462 US. 810

ES Se a ee re 14, 18, 19
Nebbia v. New York, 291 U.S. 502 (1934)............. 39
New Orleans v. FERC, 67 F.3d 947 (D.C. Cir.

EERE ne STR ES ee aee e 43
Olson v. United States, 292 U.S. 246 (1934)......... 30
Permian Basin Area Rate Cases, 390 U.S. 747

AEE ee ee 28, 40
Reno v. Flores, 507 U.S. 292 (1993).................... 25

Smyth v. Ames, 169 U.S. 466 (1898), overruled by
FPC v. Natural Gas Pipeline Co., 315 U.S. 575

TE SEE STAT SUN Re eo OTIC 3, 30, 31
TWA, Inc. v. CAB, 385 F.2d 648 (DC. Cir.
i ciessisel celts teeaaeecaitianaa emi iadeameie 44
Tennessee Elec. Power Co. v. TVA, 306 U.S. 118
IIIT iininsscidsiesciisbionsinnescieaieniuieigptnnideieipiinaiinboes 40
United States ex rel. TVA v. Powelson, 319 U.S.
cen eis iiatideteetapaalanitanigpadaidinae 30
United States v. Miller, 317 U.S. 369 (1943)......... 30
United States v. Riverside Bayview Homes, Inc.,
ESO 15, 25, 28, 33
United States v. Security Indus. Bank, 459 U.S.
II sneciininiihohtehscsidieiaelccdgtihiasaeeaahntegiicitansindiatia 25
United States vy. Winstar Corp., 518 U.S. 839
(I sevciessgiihenbaescacrocincsheiehs ibibesinguiah dilibsieaisishnaia 41
Wisconsin v. FPC, 373 U.S. 294 (1963)................ 20

vii
TABLE OF AUTHORITIES - continued

CONSTITUTION AND STATUTES Page
TT TELE ee Re 30
TET OE TNT I 14, 18

ES A ee 17, 23
SETI Indeed, there have been many recent cases in which utilities raised
taking claims under prudent-investment regimes. See infra p. 44 nn.31-
32.

34

assertions that the adoption of TELRIC represents a “switch”
in ratemaking methodologies that will deny LECs the
recovery of substantial costs that they putatively had a right to
recover under the historical prudent cost methad that
purportedly governed their operations before TELRIC was
adopted. First, the LECs rely on Duquesne’s statement that it
would “raise serious constitutional questions” if an agency
were “to arbitrarily switch back and forth between
methodologies in a way which required investors to bear the
risk of bad investments at some times while denying them the
benefit of good investments at others.” 488 U.S. at 315.
Second, the LECs’ claim that the adoption of TELRIC
breached a “regulatory compact” in which LECs made their
network investments in exchange for a guarantee that they
always would recover all of their historical investments.

These claims are legally baseless. Further, they rest on the
LECs’ extrarecord assertions that TELRIC has been, or might
be, applied in particular ways. But these claims are out of
order in an appeal from the “final agency action” that adopted
TELRIC. Compare LEC Br. 37. In addition, the claims do
not rest on competent evidence, and are demonstrably
erroneous.

The basic fallacy of both LEC claims is that TELRIC
simply does not represent a “switch” in ratemaking
methodologies. The FCC’s adoption of TELRIC to set
interconnection and network elements rates has no effect on
the ratemaking methods that govern the interstate and
intrastate telecommunications services that LECs have
historically provided. These services continue to be subject to
the ratemaking methods that were in effect before the 1996
Act was adopted and implemented. For the same reasons,
TELRIC does not “rewrit[e] the terms of thousands of
regulatory transactions [long] closed” (id. at 30), and the
rhetoric of “harsh retroactivity” and a regulatory “bait and
switch” that pervades the LECs’ Brief is simply inapt. /d. at
29, 30. That is particularly so because it has been the case for

35

more than a decade that the LECs have been subject to a price
cap regime in which they did not have any right to a return on
all historical prudent investment.

Rather than change the regulatory treatment of the LECs’
existing interstate and intrastate telephone services, the FCC
adopted TELRIC to govern the pricing of new wholesale
arrangements — interconnections and network elements — that
LECs were required to provide for the first time by virtue of
the 1996 amendments to the Communications Act. By
adopting TELRIC for this purpose, the FCC was following
the same ratemaking method that governed the setting of rates
for other essential facilities that LECs provide to their
competitors. And while the new arrangements allow new
entrants to offer local services that compete with those of the
LECs, in the nearly five years since TELRIC was adopted,
fewer than 3% of the nation’s telephone lines have switched
to firms that use unbundled network elements to offer
competing services. ”°

1. TELRIC Is Not An impermissible Switch In
Methodologies That “Strands” Investment.

The “serious constitutional questions” that Duquesne
identified arise only if an agency arbitrarily switches
ratemaking methods back and forth “in a way which required
investors to bear the risk of bad investments at some times
while denying them the benefit of good investments at
others.” Duy sesne, 488 U.S. at 315. Here, there has been no
switching of methods, much less switching back and forth.
And the effect of the adoption of TELRIC was neither to
require investors to bear the risk of bad investment nor to
deny them the benefit of good ones. In short, the LECs

*° Press Release, Federal Communications Comm'n, FCC Releases
Latest Data on Local Telephone Competition (May 21, 2000) (new
entrants serve 8.5% of lines, about one third of them using unbundled
network elements).

36

simply have not made the showing that would, in Duquesne’s
words, “raise serious constitutional questions.” /d.

The LECs are thus reduced to contending that Duquesne
adopted another very different rule, sub silentio. Specifically,
they contend that, under Duquesne, a tribunal cannot lawfully
adopt a forward-looking method nie ss it demonstrates that it
will permit a utility to achieve raies that fall with the same
range as would result from the operation of an historical
prudent-investment method. LEC Br. 27. The LECs claim
that the adoption of TELRIC violates this rule because it
allegedly was “designed” to produce network valuations that
are 50%-60% lower than those that would be produced under
a historical-cost method. LEC Br. 40. In their view, it
follows that TELRIC will unlawfully “strand” the LECs’
prudent investment. These claims have no basis even apart
from the LECs’ misplaced reliance on the concept of

“stranded investment.’

Duquesne did not adopt a rule under which regulatory
agencies could depart from historical-cost methods only if
they showed that the departure would have no substantial

?” “Stranded” investment refers to “investments in specialized, durable
assets that may have seemed necessary, or at least justifiable, when
constructed and placed into service under a regime of price and entry
controls but that have become underutilized or even useless under
deregulation,” such as an electric generation plant that is idled by an
agency order requiring transmission of competitively generated power. H.
Hovenkamp, The Takings Clause and Improvident Regulatory Bargains,
108 Yale L. J. 801, 802-03 (1999) (book review). Stranding would only
occur under the Act if the LECs’ network facilities became underutilized
because competitors constructed and used alternative facilities. By
no stranding occurs. See W. Baumol & T. Merrill, Does The Constitution
Require That We Kill The Competitive Goose? Pricing Local Phone
Service To Rivals, 73 N.Y.U. L. Rev. 1122, 1143 (1998). Because the
sole issue here relates to the rates LECs receive when they lease out their
facilities, the LECs reliance on the FERC’s stranded-cost orders is wholly

misplaced, LEC Br. 12 n.8.

37

effect on the resulting rate levels. The object of all
ratemaking is to foster efficiency and to prevent rates that
recover inefficient or wasteful expenditures. The Federal
Constitution could not preclude the adoption of a ratemaking
method merely because it is more effective in carrying out
these objects than the prudent-investment method (which the
FCC previously determined to foster inefficiencies that
regulators are incapable of preventing).

The LECs are simply wrong in arguing that Duquesne held
otherwise. Their contentions rest only on the Court’s
statement that the utility had not claimed that the “total
effect” of the revised rate order was unconstitutional, for this
order differed in only de minimis ways from the prior order
that the utility was seeking to reinstate. Duquesne, 488 U.S.
at 311-12. That was a description of the two orders, not a
statement of constitutional requirements.

Contrary to the LECs’ misstatement (LEC Br. 9, 40), the
FCC did not “adopt{] TELRIC with the express purpose of
producing prices lower than historical costs.” Rather, the
FCC determined that the competitive goals of the Act
demanded pricing based on economic costs, “which may be
higher or lower than historical embedded costs.” Order, § 705
(JA 399). And, there is palpably no basis for the LECs’ claim
that the FCC adopted TELRIC because it was designed to
value the LECs’ networks at levels 50-60% lower than would
a prudent historical-cost method. As explained above (supra
pp. 8-13), these claims rest on extrarecord assertions that are
unsupported, that rest on apples-to-oranges comparisons, and
that are inconsistent with the very data sources upon which
the LECs rely.

But even if the overall network valuations were certain to
be lower under TELRIC, that would only raise the question of
why this difference exists. If it were the product of facts that
would have foreclosed the LECs’ recovery of the difference
under strict applications of a prudent-investment
methodology, the difference obviously would have no

38

constitutional or other significance. For example, any
prudent-investment regulator would exclude from the rate
base the substantial amount of phantom assets that appear on
the LECs’ books, but that are not in use in the LECs’
networks. Continuing Prop. Records Audit, 14FCC Rcd.
7019, 7019 (¥ 1) (1999). It should similarly exclude the vast
amounts of excess capacity the LECs have installed to
provide unregulated enhanced services in the future. In this
regard, a major reason that AT&T and others advocated
TELRIC is that it is a very efficient way of determining how
the LEC networks should be sized to meet existing demand
and of preventing LECs from recovering from competitors the
costs of present excess capacity that was installed to support
the LECs’ future competitive services.

Finally, even if TELRIC were certain to produce lower
asset values and thus a lower “rate base” than would other
ratemaking methods, the “end result” could still be the same.
The effects of a lower TELRIC rate base “may well be
cancelled out by countervailing errors or allowances in
another part of the rate proceeding.” Duquesne, 488 US. at
314. Indeed, the favorable effects of depreciation” or cost-
of-capital”’ allowances may offset any effect of the different

* TELRIC permits economic depreciation that reflects expected price
declines and the risk of obsolescence associated with technological
change, Order, ¢ 686 (JA 384-85). That would result in higher depre-
particularly if it were true (compare LEC Br. 4) that regulators require

2° In Duquesne Light Co. v. Barasch, the Court held that the regulators’
exclusion of certain prudent investments from a utility's rate base raised
no constitutional issue, for the utility had received a rate-of-return higher
than the minimum that would have been required under a prudent-
investment method. 488 U.S. 299, 312 (1989). In making its
determinations under TELRIC, the FCC currently uses a rate-of-return of
11.25%, which was established in 1990. See supra p. 5n.1. That was an
exceedingly generous rate-of-return even at that time, and because interest

39

methods for valuing the rate base. Thus, the “end result”
could be the same under either method.

2. The LECs’ Regulatory Compact Claim Is
Meritless.

There is similarly no foundation for the LECs’ suggestion
that the adoption of TELRIC violated a regulatory compact in
which they built local networks in exchange for a promise
that they could recover their historical costs in rates. The
LECs assert - without citation of authority — that under any
constitutional ratemaking regime “investors expectations are
settled by a predictable mechanism that informs investors in
advance how they will be paid.” LEC Br. 24. But that
assertion is squarely foreclosed by Duquesne, which upheld a
revised rate order that excluded $35 million of investment
that was recoverable under the prior ratemaking method. 488
U.S. at 312-14. And while regulatory compacts can exist, the
LECs simply are not parties to one.

First, contracts specifying regulatory duties and
entitlements were sometimes entered into during the
nineteenth-century, usually in the form of corporate charters
to internal improvement corporations or franchises for use of
the public right-of-way. See R. Seavoy, 7he Origins Of The
American Business Corporation, 1784-1855, at 39-51 (1982).
However, this Court then held that the power to regulate rates
existed independently of any compact to dedicate property to
public use. See Munn v. Illinois, 94 U.S. 113, 125-26, 133
(1876); accord Nebbia v. New York, 291 U.S. 502, 536-39
(1934). And rate regulation was imposed on the LECs after
they had made their investment, not as the quid pro quo in a
regulatory compact. See H. Hovenkamp, 7he Takings Clause
and Improvident Regulatory Bargains, 108 Yale L. J. 801,
804-05 (1999) (book review).

rates and costs of equity are radically lower today, a much lower rate-of-
return could now be applied under a prudent-invesiment regime.

40

Further, neither the state nor federal regulatory schemes
ever guaranteed any LEC that it could recover all historical
costs. To the contrary, the LECs expanded and maintained
their networks subject to the very general standard that the
rates must be “just and reasonable,” which affords the agency
considerable “pricing flexibility” to change methodologies as
the public interest requires. Mobil Oil Exploration &
Producing S.E., Inc., 498 U.S. at 224. Under this regime, the
LECs unilaterally decide which investments to make. To
enforce the “just and reasonable” standard, regulators can
review a LEC’s investments long after they were made to
decide whether they should be included, in whole or part, in
the “rate base” under the policies that the regulatory body
then chooses to apply. See Hovenkamp, supra, at 822.

Under these systems, it is well settled that even if a
regulatory commission made an affirmative decision to
include an investment in a rate case in one year, the
commission may make a different determination in future
years by either adopting a different policy or ratemaking
standard or by applying its prior standard more rigorously.
As this Court has held, “(t]he declaration of a specific policy
creates no vested right in its maintenance in utilities then
engaged in the business,” Tennessee Electric Power Co. v.
TVA, 306 U.S. 118, 141 (1939), and a court will not “set aside
[a rate order] merely because the Commission has on an
earlier occasion reached another result” under a different
ratemaking standard. Permian Basin Area Rate Cases, 390
U.S. 747, 784 (1968).

The fact that the regulatory environment was structured to
encourage LECs to invest in their network to promote
universal service does not create a binding obligation to base
rates on historical costs. Unless the government has by
express terms of a contract committed itself to a particular
regulatory course, it is not bound to compensate a regulated
entity that claims to have relied on the prior scheme. See
United States v. Winstar Corp., 518 U.S. 839 (1996);

41

Louisville Bridge Co. v. United States, 242 U.S. 409, 420
(1917), J. Rossi, The Irony of Deregulatory Takings, 77 Tex.
L. Rev. 297, 308-09 (1998) (book review). The LECs have
no more right than any other entity to be compensated for the
inability to recover all past investment due to regulatory
change. Cf. Keystone Bituminous Coal Ass'n v.
DeBenedictis, 480 U.S. 470, 495 (1987) (describing
“regulatory takings”).
Ill. THE FCC’S REJECTION OF THE LECS’
HISTORICAL-COST PROPOSALS WAS NOT
ARBITRARY AND CAPRICIOUS.

Finally, there is no substance to the LECs’ claims that it
was arbitrary and capricious for the FCC to reject historical-
cost ratemaking and to adopt a forward-looking method. As
this Court has held, the determination of the proper cost
standard to use in setting rates is one of the “kind of basic
judgments about economic policy” that is uniquely committed
to the discretion of federal agencies and that courts are ill-
suited to second-guess. American Commercial Lines, Inc. v.
Louisville & Nashville R.R, 392 U.S. 571, 590 (1968).
Accordingly, to succeed on their claims, the LECs must show
that the FCC failed “adequately [to] consider{] the factors
relevant to choosing a rate that will best serve the purposes of
the statute” and that it “committed a ‘clear error of
judgment’” in rejecting historical-cost ratemaking. American
Paper Inst., Inc. vy. American Elec. Power Serv. Corp., 461
U.S. 402, 413 (1983). The LECs have not come close to
satisfying this demanding standard.

Indeed, the reasonableness of the FCC’s rejection of
historical cost is established by the most elementary
principles of economics and by the decade of regulatory and
antitrust decisions that provided the background to the 1996
Act and that have been discussed throughout this brief.

First, the FCC and most states had determined that
historical-cost ratemaking fosters inefficiencies that

42

regulators are incapable of controlling even in the very
different context of regulating the LECs’ overall revenues and
earnings. The regulatory task in the performance of this
function is merely determining the reasonable costs of a
regulated firm as a whole and attempting to prevent it from
earning monopoly profits. This function required no
determinations of costs attributable to individual different
facilities, functions, services, and locales. Nor did it present
the regulated firm with incentives to misallocate costs among
different facilities, functions, services, or areas to prevent or

distort competition.

Second, the FCC and states had determined that historical-
cost ratemaking methods are flatly inappropriate when the
issue is establishing the conditions that will allow competition
with retail services of the incumbent LEC. There is no truism
more elementary in all of economics than that historical costs
are irrelevant because they are “sunk” and “unavoidable,”””
and that the relevant costs to decisionmaking in competitive
markets are forward-looking costs. These are the “real” and
“economic” costs that LECs incur when they use the essential
facilities that they control to provide services at retail in
competition with other firms. For that reason, these are the
costs that the FCC and other regulatory bodies have long
relied upon in determining the rates that LECs may charge
prospective competitors for access to those essential facilities.

Against this background, to accept the LECs’ claims that
rates for network elements and interconnections should be
based on historical cost, the FCC would have had to repudiate
its own consistent prior decisions and the decisions of other
regulatory bodies and antitrust authorities. AT&T Pet’rs’ Br.
6-12. The notion that its failure to do so could have been
arbitrary and capricious stands basic principles of

A Kahn & W. Shew, Current Issues In Telecommunications
Regulation: Pricing, 4 Yale J. on Reg. 191, 225 (1987).

|

43

administrative law on their head. And there is not the
slightest substance to the claims that the LECs have made.

A. All Ratemaking Methods Are Hypothetical And
There Is No Basis For The Claim That Other
Methods Would Fulfill The Act’s Objectives At
Lower Administrative And Other Costs.

The LECs’ primary claim is that it was arbitrary to reject
their historical-cost proposals because the alternative forward-
looking method is “hypothetical” and difficult to administer.
These contentions are baseless.

1. As Professors Baumol, Willig, and Ordover testified
before the FCC, “[aj/l cost-based ratemaking standards
(including embedded cost ratemaking) involve hypothetical
constructs.” Baumol et al. Reply Aff. at 6 n.4 (JA 147).
Prudent historical-investment and replacement-cost methods
are both “hypothetical” for each seeks to foster efficiency by
determining not what the utility is spending, but what it
should be spending. The only difference is that one method
makes hypothetical determinations by looking “forward” and
the other by looking “backward.”

TELRIC and other efficient replacement-cost methods
determine the particular facilities that are required to meet the
existing demand and what it would cost to construct and
operate them from the “bottom up.” It thus determines what
an appropriately sized network should cost by looking

forward.

Prudent historical-investment ratemaking makes the same
determination on a backward-looking basis. It begins with
the utility’s existing assets and determines whether they
should have been configured differently. But it does so by
examining all of the historical decisions that caused the
existing configurations to decide whether they are ones that
“reasonable utility management . . . would have made, in
good faith, under the same circumstances, and at the relevant
point in time.” New Orleans v. FERC, 67 F.3d 947, 954

44

(D.C. Cir. 1995). As Judge Levanthal stated, “a conclusion of
imprudence reflects a view of how business should be
conducted.” 7WA, Inc. v. CAB, 385 F.2d 648, 656 (D.C. Cir.
1967).

In circumstances where costs were rising rapidly and
commissions had strong incentives to determine if utilities
had acted inefficiently in ways that harm the public,
applications of the prudent-investment methodology have
entailed extraordinarily detailed retrospective reviews of all
the stages in a utility’s internal decisionmaking processes
over long periods of time. Based on these archeological
expeditions, commissions have made assessments of the
reasonableness of each incremental investment made during
that period.*' When imprudence is found, commissions then
determine what costs the utility would have incurred in the
hypothetical world in which it had been prudent. These
inquiries entail such things as deciding what costs would have
been if construction of a new plant had or had not been
temporarily halted, abandoned or accelerated; if the utility
had or had not sold off certain facilities and purchased
substitutes; or if the utility had managed itself differently in
myriad other respects.”

2. One reason that leading economists urged a forward-
looking method is that there is evidence the existing LEC
networks are inefficient, contain phantom assets, and were
intentionally overbuilt with capacity that is not needed to
meet existing demand, but that will be used only to provide
unregulated enhanced and other new services in the future.

3! See, e.g., Long Island Lighting Co. v. PSC, 523 N.Y.S.2d 615 (N.Y.
App. Div. 1987); Kansas Gas & Elec. Co. v. State Corp. Comm'n, 720
P.2d 1063 (Kan. 1986), vacated in part, 481 U.S. 1044 (1987), Entergy
Gulf States, Inc. vy. Louisiana PSC, 726 So.2d 870 (La. 1999).

32 See cases cited in n.31. See also, e.g., Consumers’ Counsel v. FERC,
914 F.2d 290, 296 (D.C. Cir. 1990); Connecticut Light & Power Co., 43
FERC 4 63,029, at 65,228, 65,231 (1988).

45

See supra pp. 7-8. In this context, TELRIC and other
forward-looking methods are the lowest cost methods of
determining the efficient level of investment required to meet
the existing demand, for they simply size and then cost a
network from the “bottom up.”

By contrast, the administrative and litigation costs of
rigorously making these same determination under a
backward-looking __historical-cost method would be
prohibitive. It would require penetrating the LECs’ books
and reviewing years of network planning decisions. The
problems would have been radically compounded by the fact
that the objective of the 1996 Act is not to determine the
LECs’ average statewide costs, but to determine the costs that
LECs incur in providing services in discrete areas having
different population densities and terrain. Order, 9 965 (JA
439). Because the LECs’ historical costs are kept on state-
wide or similar bases, this would have required allocations of
book costs that would be complex and arbitrary. In short, the
LECs have it exactly backwards in claiming that a prudent
historical-cost approach would have helped in “speeding the
transition to competition.” LEC Br. 46. If rigorously applied
in an attempt to foster the Act’s procompetitive goals, a
prudent-investment method would be slower, not speedier,
and more expensive, not cheaper. Furthermore, as the FCC
found, the end result of that process likely would have been
rates that impede or foreclose competition, not rates that
promote it. Order, J 705 (JA 398-99).

3. The LECs’ claims that forward-looking costing is
administratively infeasible rest primarily on Justice
Brandeis’s 1923 opinion that criticized fair value ratemaking
and summarized his reasons for then believing prudent-
investment methods could achieve the same benefits at lesser
costs. LEC Br. 45. But Justice Brandeis was addressing the
determinations of the costs of service of an entire firm based
on its books — where the sole object is to prevent the firm

46

from earning monopoly profits.*’ He was not addressing the
matter of determining the cost of providing different facilities
and functions in different locales - where the object is to
assure that incumbent monopolists and their competitors
obtain the same essential facilities at the same economic
costs. Justice Brandeis also made his statements before there
had been any experience with prudent-investment ratemaking,
much less the experience that caused it to be rejected by the
FCC and most states for the purpose for which Justice
Brandeis had thought it to be well suited. This was also long
before replacement cost pricing was not only proven
eminently feasible, but also became commonplace, by the
developments in computer modeling in more recent decades.
Finally, Justice Brandeis manifestly did not argue that a
commission should be required to use prudent investment if it
determined based on experience that another method would
be more effective for a different purpose.

The reality is that by 1996,\ forward-looking incremental
costing approaches were the norm in this context. They had
been successfully used for years by states in setting LEC
prices for individual services and facilities, and the states had
begun to apply long run incremental cost (“LRIC”) methods
to the pricing of network elements. See Order, J 631 (JA
334-36). Indeed, they are such a staple of state regulatory
oversight that LRIC cost studies are required by statute in
many jurisdictions.°* LRIC had been used by antitrust courts
in resolving claims that Bell companies had engaged in
predatory pricing by pricing individual services below their

*° Similarly, this was the subject matter of the FCC’s 1992 Order that
adopted historical-cost regulation to regulate retail cable television rates.
Implementation of Sections of the Cable Television Consumer Protection
and Competition Act of 1992: Rate Regulation, 9 F.C.C.R. 4527 (1994).

220 Ill. Comp. Stat. 5/13-502(c); Mich Comp. Laws Ann.
§ 484.2208(9); Minn. Stat. Ann. §§ 237.59, 237.772; Tex. Util. Code Ann.
§ 58.055(c); Utah Code Ann. § 54-8b-3.3(5); Wy. Stat. Ann. § 37-15-
402(a).

47

relevant costs, by the Surface Transportation Board in pricing
railroad services; and now has been adopted by the European
Commission in opening its local markets to competition. See
AT&T Pet’rs’ Br. 8-12, 19-21, 32-33. The LECs also ignore
that the FCC’s thoughtful and well-supported predictive
judgment has been proven correct — notwithstanding the
LECs’ claims of administrative unfeasibility, virtually all
states have, in fact, managed to apply forward-looking pricing
principles to estimate efficient replacement costs and
establish network element and interconnection rates. See id

at 21 n.23.”

In light of this experience, the LECs grasp at straws in
contending that the FCC did not provide adequate explanation
of the administrability of TELRIC. Indeed, in addition to
relying on the state regulatory experience, the FCC conducted
“an initial examination” of various LRIC computer models
that were submitted for the record, and concluded that “the
remaining practical and empirical issues can be resolved in
the near future.” Order, J 835 (JA 433).

Certainly, the FCC’s expert determination of what methods
are most cost effective is entitled to substantial deference,
particularly where, as here, most of the LECs’ complaints
about administrability are simply anachronistic.

*® The LECs falsely claim that it took the FCC four years “of revising
and updating various cost models” to “finally decide that TELRIC could
be used to project costs accurately.” Br. at 45. In fact, the FCC never
wavered from its initial proposal that universal service costs, like network
element and interconnection rates, should reflect forward-looking costs.
And the proceedings to choose a particular cost model and inputs were
completed in less than twenty-eight months, Federal-State Joint Bd on
Universal Serv., 14 FCC Red. 20156, 20161 (¥ 5) (1999), notwithstanding
the LECs’ steadfast refusal to cooperate and provide customer location

48

B. Competitive Pricing Of Network Elements Does
Not Frustrate The Act’s Purposes.

In the last two pages of their brief, the LECs make five
cursory arguments that TELRIC is contrary to the Act. LEC
Br. 48-49. One is a claim that they promise to elaborate on in
their response brief to AT&T’s and the FCC’s appeal. AT&T
will address that argument in its Petitioner’s Reply Brief. The
other four arguments can be summarily dismissed.

First, relying on an out-of-context statement from Justice
Breyer’s separate opinion in AT&T Corp. v. Iowa Utilities
Board, 525 U.S. 366, 424 (1999), the LECs claim that the
adoption of TELRIC short-circuits the “process” of
competition and seeks to mandate a set of retail prices that
would represent the “‘end result” of competition. LEC Br.
48 (emphasis omitted). But Justice Breyer addressed the
initial FCC rules in which there was no “limit” on the
facilities that could be leased as network elements under
TELRIC. Under the FCC’s current rules, the only facilities
that can be leased from the LECs are those that competitors
plainly need to offer competing services. As the FCC’s
findings establish, the availability of these facilities at
TELRIC-based rates is thus necessary for competition to
develop in the “unshared” parts of the network and to begin a
“process” that will drive retail prices closer to competitive
levels. Compare 525 U.S. at 430. By contrast, as the FCC
found, if LECs could impose higher prices under a historical-
cost method, the LECs could foreclose even the limited
competition that has developed in the last five years. Order,
q 705 (JA 398-99).

Second, LECs claim that the FCC did not justify its
assertions that historical costs would foster inefficient entry,
and wonder how higher rates could induce inefficient
competitors to enter the market. But the FCC’s point, fully
explained in the order, was that the entry — not the entrants —
would be inefficient if prices did not reflect true economic
costs. The FCC repeatedly pointed out that inflated network

49

element rates provide improper price signals and would cause
investments in facilities that LECs can provide at a lower
economic cost than any new entrant. See Order, 99 620, 635-
636, 679, 708-711 (JA 327-28, 340-43, 379-80, 401-03).

Third, the LECs claim that the FCC ignored the threat to
genuine competition from UNE prices that are too low. The
LECs here simply repeat their unfounded claim that TELRIC
does not represent the economic costs of providing the
elements. If prices for essential inputs are set at economic
costs, there is no underpricing. Moreover, given the high
transactions costs of leasing network elements, new entrants
still have ample inducement to engage in facilities-based
competition, as AT&T is doing. See AT&T Pet’rs’ Br. 14-15.
In any event, Congress did not favor one entry strategy over
another, Order J 12 (JA 271-72), and efficiency in network
element rates is not to be sacrificed based on projected and
dubious effects on facilities-based competition.

Finally, the LECs renew their regulatory-compact
arguments, now under the arbitrary-and-capricious banner,
claiming that the opportunistic changing of regulatory rules
will be a disincentive to future investment. But it is Congress
that has set the rules of this game; the FCC has simply
adopted methods consistent with those rules and suited for the
new competitive environment. Moreover, TELRIC is
structured to ensure a return on investment, see supra pp. 21-
23, and it gives the same incentives to capital investment as
exist in a competitive market.

50

CONCLUSION

For the reasons stated, the Eighth Circuit decision should be
affirmed insofar as it upheld forward-looking pricing.

Respectfully submitted,
MARK C. ROSENBLUM DAVID W. CARPENTER*
LAWRENCE J. LAFARO PETER D. KEISLER
RICHARD H. RUBIN DAVID L. LAWSON
AT&T Corp. STEPHEN B. KINNAIRD

295 North Maple Avenue C. FREDERICK BECKNER III
Basking Ridge, NJ 07920 SIDLEY AUSTIN BROWN &
(908) 221-8410 Woop
1722 Eye St., N.W.
Washington, D.C. 20006
(202) 736-8000

- Counsel for Respondent
June 8, 2001 * Counsel of Record

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/brief%3Amicro_IA40385014_0419%3A19. Public record. Not legal advice.