Respondents Brief — General Communications, Inc. v. Iowa Utilities Board

JUN 3 200]

Nos. 00-511, 00-555, 00-587, 00-590 &400-602

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Supreme Court of the United States —

FEDERAL COMMUNICATIONS COMMISSION, ef al.,

Petitioners,

V.

IOWA UTILITIES BOARD, et al.,

Respondents.

On Writ of Certiorari to the

United States Court of Appeals

for the Eighth Circuit

BRIEF FOR RESPONDENT QWEST

COMMUNICATIONS INTERNATIONAL, INC.

R. STEVEN DAVIS WILLIAM T. LAKE

LAWRENCE D. Huss Counsel of Record

SHARON J. DEVINE JOHN H. HARWOoD II

ROBERT B. MCKENNA SAMIR C. JAIN

QwWEST COMMUNICATIONS RUSSELL P. HANSER

INTERNATIONAL, INC. Scott A. SHEPARD

1801 California Street WILMER, CUTLER & PICKERING

Denver, Colorado 80202 2445 M Street, N.W.

(303) 672-2861 Washington, D.C. 20037-1420

(202) 663-6000

Counsel for Respondent

Qwest Communications International, Inc.

June 8, 2001

IBEST AVAILABLE COPY

QUESTION PRESENTED

Whether an FCC rule concerning the rates an incumbent

local telephone company may charge competitors for sharing

its facilities is contrary to the Telecommunications Act of

1996 and arbitrary and capricious because the rule ignores

the incumbent’s real-world network and costs and instead

sets rates based on an estimate of the costs that a hypothetical

carrier would incur if it built and rebuilt a new ideal network

using the least-cost, most efficient available technologies.

(i)

CORPORATE DISCLOSURE STATEMENT

Pursuant to Supreme Court Rule 29.6, respondent Qwest

Communications International, Inc. states as follows:

Respondent Qwest Communications International, Inc. is

a publicly held corporation that has no parent company.

Through its operating subsidiaries, Qwest Communications

International, Inc. provides broadband Internet-based data,

voice, and image communications for business and consum-

ers. No publicly held company owns ten percent or more of

Qwest Communications International, Inc. stock.

U S WEST, Inc. merged with and into Respondent

Qwest Communications International, Inc. on June 30, 2000.

U S WEST, Inc. was formerly the parent and sole share-

holder of U S WEST Communications, Inc. U S WEST

Communications, Inc. was renamed Qwest Corporation on

July 6, 2000. Qwest Corporation is a wholly owned subsidi-

ary of Qwest Communications International, Inc. Qwest

Corporation is a local exchange carrier that provides local

exchange telecommunications, exchange access, information

access, data services, wireless services, and intraLATA long

distance services pursuant to tariff and contract.

TABLE OF CONTENTS

Page

IID crescnnssncesessassssenscnssevsncescensnssacessees i

CORPORATE DISCLOSURE STATEMENT ...................+. ii

TABLE OF AUTHORITIES. ...........:cc0scccscscssssssssssssssereeseess Vv

IIIT tt iteststcentennsssnsnsssssansnssccsssssssccosscevscsesece 1

FURIBDICTION .ncvcocecsccscsesesecesesecesesssesesesesesesesesesecssosesesessers I

PERTINENT STATUTORY PROVISIONS ..}...........:c000000008 l

STATEMENT OF THE CASE .............0sccccsccssssssrssessssseseees I

A. The Telecommunications Act of 1996 .............00++ 3

B. The FCC’s Notice of Proposed Rulemaking ......... 5

C. The FCC’s Local Competition Order .................... 7

D. Subsequent Proceedings ............cccceeeereeereeeees 10

SUMMARY OF ARGUMENT ...........:ccccccceseersseseeesneenees 12

a 14

I. TELRIC IS FLATLY INCONSISTENT WITH

THE TEXT OF THE STATUTE. .............cccccceeeeeseees 14

Il. THE FCC’S METHODOLOGY IS NOT DE-

REGULATORY, CREATES ARTIFICIAL IN-

CENTIVES, AND DISCOURAGES _INVEST-

MENT, ALL IN DIRECT CONTRAVENTION OF

THE ACT’S PURPOSES AND POLICY. ................. 18

A. The FCC’s Order Distorts Entry and Investment

Incentives by Relying on Regulation Rather

than the Marketplace. ............:ccecccssesesrrssereeeenes 21

B. The Order Creates Disincentives to Investment

by Both CLECs and ILECS. ............ccccceseeseeeeneees 23

(iii)

iv

TABLE OF CONTENTS — Continued

Ill. THE FCC’S METHODOLOGY IS ARBITRARY

AND CAPRICIOUS ON ITS OWN TERMS BE-

CAUSE IT IS BASED ON ERRONEOUS AS-

SUMPTIONS THAT DO NOT REFLECT HOW

REAL-WORLD MARKETS OPERATE. ...............--. 29

IV. THE ACT PERMITS THE FCC TO IMPLEMENT

OTHER FORWARD-LOOKING METHODOLO-

GIES MORE CONSISTENT WITH THE STATU-

PRS POT CIEDS ccccccccssscsszsssssssnsnsnsnncssssnscenssassttanens 38

oe 42

Vv

TABLE OF AUTHORITIES

CASES Page(s)

AT&T v. lowa Utilities Board, 525 U.S. 366 (1999) .. passim

Barry Wright Corp. v. ITT Grinnell Corp., 724 F.2d

PUTED GRIITD snadescntrcnnspesneemeinenstintmmtemneeeeneen 37

California Dental Ass'n v. FTC, 526 U.S. 756

SEITE stacsenintinentendatiinunisetammensuniorensiditamiaubememsienenens 17

Central Lincoln Peoples’ Utility District v. Johnson,

pol §| of ol fd) 38

Connecticut National Bank v. Germain, 503 U.S.

pea ITED ccnniinasecnenerepetapenspenantinietennepnptinntasinsinnndectinanite 15

FPC v. Hope Natural Gas Co., 320 U.S. 591 (1944) ......... 18

Iowa Utilities Board v. AT&T, 120 F.3d 753 (8th

i, TTD dincereiencenncienensnnnninennensnnedsnemainntaseatenbemeeenne 10

lowa Utilities Board v. FCC, 219 F.3d 744 (8th Cir.

TITTED deniisttheninctbeenennnsenntentmmetennnteiaeniiiinds 1, 11, 12, 16

John Hancock Mutual Life Insurance Co. v. Harris

Trust & Savings Bank, 510 U.S. 86 (1993) ............000+. 18

MCI Communications Corp. v. AT&T, 708 F.2d

ee 36, 37

Neder v. United States, 527 U.S. 1 (1999) 0.......ccccccceeeeeeeee 18

Norwood v. FERC, 962 F.2d 20 (D.C. Cir. 1992) ............. 38

Securities Industry Ass'n v. Board of Governors of

the Federal Reserve System, 468 U.S. 137

See een. eC 18

United States v. Wells, 519 U.S. 482 (1997) .............ccccceee 15

Wisconsin v. FPC, 303 F.2d 380 (D.C. Cir. 1962),

Ges BEe Oh SPO ISEED cet 18

STATUTES

Ee ec een ae 1

AIT TITTIITIED osn crates caeltememasiiiiteemiammientameniitiden l

TE ITIIIIID ccccrtrsnntitinnatinasepenmnemienetesemineemninnsmesseanes 19

gk FETE See ee ne 1

Ge WEEE. © TCIEED ccncscnenssscsnsscscesscessasescesnsscsnsscssesensses 5, 22

vi

TABLE OF AUTHORITIES — Continued

Page(s)

I iit retattnienlttenitiiiiadiliae 5, 28

I ii alii allaalatalintlal iil leat eae 2

i al 5

A EE ae Ae er nT 5, 22

I ii i i aati didatinins 5, 22

I al 4

I i ai et 4

TE ERR a eee mee See ae 4

A eae re 2, 5, 14, 15

i 5, 22

A EERE Sse en ee a SEIT om 3

RULES & REGULATIONS

I ian enaitinsnintetinliiinatdiataans ]

8 a a 2, 8, 14, 30

NI iii caiacaneienciniitneneachinsceerimiemanitiaidaaasiniiaite 36

LEGISLATIVE MATERIALS

H.R. Conf. Rep. No. 104-458 (1996) ..............0. 3, 4, 19, 20

H.R. Rep. No. 104-204 (1995) .0......ccececceseseeeseeeeeeeeeenenees 16

A CPI cnrerncertcncerememnpeanmmnntsientncnntananiane 16

Communications Law Reform: Hearings Before the

Subcomm. on Telecommunications and Finance

of the House Comm. on Commerce, 104th

DED cnceensiiennenteenetsnnntninnseensnnennenemninentie 20

DOE Comte, TBS. TRISSD CIID cccscccccccssscssccssscssssscresvensssseses 20

ADMINISTRATIVE RULINGS

Access Charge Reform, First Report and Order, 12

FCC Red 15,982 (rel. May 16, 1997) ..........cccccceeeeeeee 22

Vii

TABLE OF AUTHORITIES — Continued

Page(s)

Coal Rate Guidelines, Nationwide, | 1.C.C.2d 520

(1985), aff'd sub nom. Consolidated Rail Corp.

v. United States, 812 F.2d 1444 (3d Cir. 1987) .... 34, 37

Implementation of the Local Competition Provisions

in the Telecommunications Act of 1996, Notice

of Proposed Rulemaking, 11 FCC Rcd 14,171

Ge, GAR: TEA, CEI ccecssnsvanccscnsvesecssesnsscnesmsssesssenmneenenees 6

Implementation of the Local Competition Provisions

in the Telecommunications Act of 1996, First

Report and Order, 11 FCC Red 15,499 (rel.

Gm. GB, TEED ccccscssnevescesssssmersnnsssemnsmansesnemensesenn passim

Implementation of the Local Competition Provisions

of the Telecommunications Act of 1996, Third

Report and Order, 15 FCC Red 3696 (rel. Nov.

5, 1999) review pending, United States Telecom

Ass'n v. FCC, Nos. 00-1015 & 00-1025 (D.C.

0 ae 11, 19, 26, 27, 28

Michigan Public Service Commission, Re A Meth-

odology to Determine Long Run Incremental

Cost, 156 P.U.R.4th 1, Exhibit A (1994) ...........ccccccsees 6

BOOKS & ARTICLES

3A Philip E. Areeda & Herbert Hovenkamp, Anti-

og bt eee 20

Phillip Areeda & Donald F. Turner, Predatory Pric-

ing and Related Practices Under Section 2 of

the Sherman Act, 88 Harv. L. Rev. 697 (1975) ........... 37

William J. Baumol & Thomas W. Merrill, Does the

Constitution Require that We Kill the Competi-

tive Goose? Pricing Local Phone Services to

Rivals, 73 N.Y.U. L. Rev. 1122 (1998) ............00.. 30, 31

William J. Baumol, Economic Theory and Opera-

tions Analysis (4th ed. 1977) .........c.cccccseeeeeeeeeeeeeeenenees 39

viii

TABLE OF AUTHORITIES — Continued

Page(s)

William J. Baumol, Janusz A. Ordover, & Robert D.

Willig, Parity Pricing and Its Critics: A Neces-

sary Condition for Efficiency in the Provision of

Bottleneck Services to Competitors, 14 Yale J.

a 33, 40

James C. Bonbright, Albert L. Danielsen & David

R. Kamerschen, Principles of Public Utility

Pr 22, 34, 38, 39

Jerry A. Hausman & J. Gregory Sidak, A Consumer-

Welfare Approach to the Mandatory Unbun-

dling of Telecommunications Networks, 109

ee is PP NEED ctsememeni 27

Alfred E. Kahn, Letting Go: Deregulating the Proc-

ess Of Deregulation (1998) .............cccccccceeeeeeeeeeeeees 23, 41

Alfred E. Kahn, The Economics of Regulation:

Principles and Institutions (1988) .............cc.ss0ee0ee00e 39

Alfred E. Kahn, Timothy Tardiff & Dennis L.

Weisman, The Telecommunications Act at three

years: an economic evaluation of its imple-

mentation by the Federal Communications

Commission, 11 Info. Econ. & Pol’y 319

GOED cnensensstemsinmeeiinmaene 24, 28, 31, 33, 35

Steven E. Landsburg, Price Theory and Applica-

RGSS, CSEe enema 17

J. Robert Malko & Philip R. Swensen, Pricing and

the Electric Utility Industry in Public Utility

Regulation: The Economic and Social Control

GSES enna 38

Joseph A. Schumpeter, Capitalism, Socialism and

Democracy (36 6d. 1950) .....0.ccccsrcsssccccsscsssseseesseseeeees 35

J. Gregory Sidak & Daniel F. Spulber, Givings, Tak-

ings and the Fallacy of Forward-Looking

Costs, 72 N.Y.U. LJ. 1068 (1997) .0......ccccceeeeeeees 30, 35

ee

—_

ix

TABLE OF AUTHORITIES — Continued

Page(s)

J. Gregory Sidak & Daniel F. Spulber, The Tragedy

of the Telecommons: Government Pricing of

Unbundled Network Elements under the Tele-

communications Act of 1996, 97 Colum. L.

a 34, 40, 41

MISCELLANEOUS

Bell Atlantic Reply Comments, CC Dkt. No. 96-98

Se Sk, STE cennieenesenniminnnemmmniimnnen 6, 7, 32

Black’s Law Dictionary (6th ed. 1990) ..............cccceeeeeeeeeees 17

Cox Communications Comments, CC Dkt. No. 96-

FP EE ea COD ccsnccssscesenprsvensensesacessnsenessnnnmnesesesens 27

GTE Comments, CC Dkt. No. 96-98 (May 16,

EIEN? ‘cssnesesrcenssesnnsnnitennmnmnmmosnmenmiinmennth 7, 18, 29, 30

MCI Comments, CC Dkt. No. 96-98 (May 16, 1996)........ 38

U S WEST Comments, CC Dkt. No. 96-98 (May

BG, FDTD cecececcszssesvecssnsssssssnssessnenssneecnsnsnesouseunsneessvecnsest 33

OPINION BELOW

The opinion of the United States Court of Appeals is re-

ported at 219 F.3d 744 and reprinted at pages 1a-43a of the

Petitioner's Appendix in No. 00-511 (“Pet. App.”). That

opinion reviewed and vacated portions of the Federal Com-

munications Commission’s First Report and Order, /mple-

mentation of the Local Competition Provisions in the Tele-

communications Act of 1996, CC Dkt. No. 96-98 (rel. Aug. 8,

1996) (the “order”), and accompanying regulations. The or-

der is reported at 11 FCC Rcd 15,499 and reprinted in rele-

vant part at J.A. 264-452.

JURISDICTION

The judgment of the court of appeals was entered on

July 18, 2000. The government filed its petition for a writ of

certiorari in No. 00-587 on November 29, 2000. This Court

granted that petition, and related petitions, on January 22,

2001, and has jurisdiction pursuant to 28 U.S.C. § 1254(1).

PERTINENT STATUTORY PROVISIONS

This case involves sections 251 and 252 of the Tele-

communications Act of 1996, 47 U.S.C. §§ 251, 252, section

706 of the Administrative Procedure Act, 5 U.S.C. § 706, and

Federal Communications Commission regulations codified at

47 C.F.R. §§ 51.501-51.511. These provisions are reprinted

at Pet. App. 152a-177a.

STATEMENT OF THE CASE

This case concerns an issue that is central to the goal of

the Telecommunications Act of 1996 (“1996 Act”) to create

real competition in the local telephone market: what prices

incumbent local exchange carriers (“incumbents” or

“TLECs”) may charge when they are required to share their

facilities with new competitive local exchange carriers

(“CLECs”). Congress directed that these prices be based on

the cost of providing the facility involved. The FCC, how-

2

ever, determined that these prices should be based on the to-

tally theoretical cost of a newly constructed, idealized net-

work that “use[s] the most efficient telecommunications

technology currently available and the lowest cost network

configuration.” 47 C.F.R. § 51.505(b)(1). The United States

Court of Appeals for the Eighth Circuit vacated this pricing

rule. That decision should be affirmed.

By passing the 1996 Act, Congress signaled its desire to

foster, on a nationwide basis, what technological develop-

ments now permit: real competition between local telephone

service providers. Congress specifically sought to encourage

rival competitors to deploy alternative network facilities. At

the same time, it recognized that, at least in the short term,

new entrants would not be able to construct ubiquitous net-

works. Accordingly, Congress enabled entrants to lease in-

dividual pieces of the incumbents’ facilities, called unbun-

died network elements or UNEs. Congress required that the

prices for such UNEs be based on “the cost . . . of providing

the . . . network element,” 47 U.S.C. § 252(d)(1), and it

charged the Federal Communications Commission (“FCC”)

with devising guidelines by which state public utility com-

missions would determine UNE prices.

The FCC adopted a forward-looking pricing methodol-

ogy that it called TELRIC — short for total element long run

incremental cost. That methodology does not attempt to de-

termine the forward-looking costs that an JLEC will incur in

providing an element. Rather, with a single unexplained ex-

ception, the FCC’s methodology ignores altogether the

ILEC’s existing network and the iterative process by which

an actual network is built. In its place, the methodology at-

tempts to estimate the costs that a hypothetical carrier would

incur if, each time a CLEC seeks to purchase a UNE, the hy-

pothetical carrier instantaneously constructed an entirely new

network using the least-cost, mosi-efficient available tech-

nologies and network configuration.

3

As the court of appeals held, while the FCC has discre-

tion to determine the cost of providing an element using for-

ward-looking costs, the 1996 Act does not give the agency

authority to ignore altogether the ILEC’s costs of providing

an element. The FCC’s mandate of the TELRIC methodol-

ogy accordingly was a fatally flawed implementation of the

Act. Whatever its role as a theoretical economic construct,

TELRIC as applied by the FCC is so extreme that it signifi-

cantly undermines the very purposes of the Act. In relying

on such a methodology, the FCC thwarted the development

of the real-world competitive process that Congress intended

to permit, and instead created a marketplace distorted by arti-

ficial regulatory incentives concerning investment and entry.

The FCC’s TELRIC methodology cripples the incentives of

CLECs and ILECs to invest in competitive facilities, and,

contrary to the FCC’s claim, fails to reflect how real-world

markets operate. The court of appeals properly recognized

that TELRIC therefore is directly contrary to Congress’s in-

tent, and that court’s decision to vacate the portion of the

FCC’s rules that bases prices on a hypothetical, ideally effi-

cient network should be affirmed.

A. The Telecommunications Act of 1996

The 1996 Act marked Congress’s rejection of the prem-

ise that local telephone service is a natural monopoly. See

AT&T v. lowa Utils. Bd., 525 U.S. 366, 371 (1999). Con-

gress instead embraced the notion that technological ad-

vances have made local service competition possible. See

id.; H.R. Conf. Rep. No. 104-458, at 113, 148 (1996) (“Conf.

Rep.”). It sought broadly to encourage that competition and

the rollout of new advanced technologies in all telecommuni-

cations sectors and in all regions. See Conf. Rep. at 113. To

achieve this objective, Congress ended the monopoly fran-

chises previously granted by the states, preempting any state

or local law that “may prohibit or have the effect of prohibit-

ing the ability of any entity to provide any interstate or intra-

state telecommunications service.” 47 U.S.C. § 253(a).

4

Congress recognized that, at least in the near term, new

entrants in the local telephone market may be unable to de-

ploy ubiquitous network facilities. See Conf. Rep. at 148.

As a result, the Act provides three distinct routes by which a

carrier can begin to offer competing local service without

deploying a complete network. First, any carrier may, on

request, interconnect its network facilities with the facilities

of an incumbent LEC, allowing customers of different carri-

ers seamlessly to call each other. See 47 U.S.C. § 251(c)(2).

Second, CLECs may obtain access to selected pieces of the

incumbent’s network as unbundled network elements “at any

technically feasible point . . . in a manner that allows request-

ing Carriers to combine such elements in order to provide . . .

telecommunications service.” Jd. § 251(c)(3). Third, CLECs

may buy complete services from the incumbent at wholesale

prices and resell those services. See id. § 251(c)(4).

The legislative history of the Act confirms that Congress

believed that “meaningful facilities-based competition is pos-

sible.” See, e.g., Conf. Rep. at 148. It confirms, too, what

the logic of the Act and basic economics suggest: Congress

intended to encourage facilities-based competition no less

than competition using UNEs or service resale. Congress

sought “to provide ... a pro-competitive, de-regulatory na-

tional policy framework designed to accelerate... deploy-

ment of advanced telecommunications and information tech-

nologies . . . by opening all telecommunications markets to

competition.” /d. at 113 (emphasis added); id. at 1 (the Act

was intended to “accelerate rapidly private sector deployment

of advanced telecommunications and information technolo-

gies”). Ths, any interpretation that prefers competition by

means of UNEs or resold services over facilities-based com-

petition is a serious misreading of the Act.

Indeed, the Act places limits on the availability and pric-

ing of UNEs precisely to ensure that CLECs’ rights to use

UNEs will not be so broad as to stifle the CLECs’ incentives

to deploy facilities of their own (or to stifle incentives for

5

ILECs to invest in new facilities). See, e.g., lowa Utils. Bd.,

525 U.S. at 387-92 (relevant language “requires the FCC to

apply some limiting standard, rationally related to the goals

of the Act”). Not every network facility must be unbundled

and provided to competing carriers. Congress charged the

FCC with “determining what network elements should be

made available.” 47 U.S.C. § 251(d)(2). In fulfilling that

charge,

the Commission shall consider, at-a minimum,

whether—

(A) access to such network elements as are proprie-

tary in nature is necessary; and

(B) the failure to provide access to such network

elements would impair the ability of the telecom-

munications carrier seeking access to provide iiie

services that it seeks to offer.

Id. (emphasis added). This mandate has come to be referred

to as the “necessary and impair standard.”

For UNE pricing, Congress relied first on incumbents

and new entrants to negotiate prices in the context of broader

interconnection agreements. See id. § 252(a). The statute

allows carriers to bargain “without regard” to the Act’s re-

quirements, including the provision concerning pricing of

UNEs. Id. §§ 251(c)(1), 252(a)(1), 252(e)(2)(A). Only if the

parties cannot reach agreement may state commissions set

UNE prices through arbitration proceedings. See id.

§ 252(b). Such UNE prices must be “based on the cost (de-

termined without reference to a rate-of-return or other rate-

based proceeding) of providing the . . . network element,”

must be “just and reasonable,” and “may include a reasonable

profit.” Id. § 252(d)(1).

B. The FCC’s Notice of Proposed Rulemaking

On April 19, 1996, the FCC released a notice of pro-

posed rulemaking to implement the local competition provi-

6

sions of the Act. Implementation of the Local Competition

Provisions in the Telecommunications Act of 1996, Notice of

Proposed Rulemaking, 11 FCC Rcd 14,171 (re. Apr. 19,

1996). The FCC posited that the UNE pricing provisions of

the Act “appear[] to contemplate the use of . . . forms of cost-

based price regulation, such as . . . the setting of prices based

on a forward-looking cost methodology that does not involve

the use of an embedded rate base, such as long-run incre-

mental cost (LRIC).” Jd. { 123. It pointed to some state laws

as examples of the model that it contemplated, id. { 127, in-

cluding a Michigan law requiring that the “[t]echnology used

in a long-run incremental cost study should be the least-cost,

most efficient technology that is currently available for pur-

chase.” See Michigan Public Service Commission, Re A

Methodology to Determine Long Run Incremental Cost, 156

P.U.R.4th 1 (1994), Exhibit A. Under this principle, “the

selection of the least cost technology is not based on the eco-

nomics of adding to the current stock of telecommunications

equipment providing service today, but rather assumes no

equipment is currently in service and a completely new net-

work is to be installed.” Jd. (internal quotations omitted).

Many commenters objected to the use of the pricing

methodology contemplated by the FCC. They submitted tes-

timony by economists such as Alfred Kahn and Timothy

Tardiff, who challenged the premise “that the proper basis for

the pricing of LEC services.sold to competitors ... is the...

the total forward-looking cost of a hypothetical, ideally effi-

cient system built by either the incumbent or some other car-

rier starting with a blank slate, using the most efficient cur-

rent technology.” Bell Atlantic Reply Comments, Kahn &

Tardiff Decl. ¢ 8, CC Dkt. No. 96-98 (May 30, 1996). Kahn

and Tardiff rejected the view that a “blank-slate” approach

would mimic “the level to which competition would drive

prices... . In a world of continuous technological progress,

it would be irrational for firms constantly to update their fa-

cilities in order completely to incorporate today’s lowest-cost

technology, as though starting from scratch: investments

7

made today . . . would instantaneously be outdated tomorrow

and, in consequence, never earn a return sufficient to justify

the investments in the first place.” Jd. Kahn and Tardiff

concluded that fostering the development of a real competi-

tive marketplace requires that entrants be allowed to compete

against the JLEC’s costs, not those of a hypothetical, most

efficient firm: “considerations of economic efficiency re-

quire that the prices charged to competitors be based upon

the LECs’ actual costs; to the extent competitors can provide

these inputs more efficiently than the LECs, this will fully

preserve their incentive to do so and thereby promote effi-

cient facilities-based entry.”' Id. (emphasis in original).

C. The FCC’s Local Competition Order

The FCC released the order on review on August 8,

1996. In addressing which facilities ILECs must unbundle as

UNEs, the order read the Act to “impose[] on an incumbent

LEC the duty to provide all network elements for which it is

technically feasible to provide access on an unbundled ba-

sis.” J.A. 288, 292-93 (Order ¥] 278, 286-87) (emphasis

added). The FCC “decline[d] to adopt” the view that the

| Other economic witnesses voiced similar concerns about the FCC’s

proposed model. As one noted, using such a model would guarantee that

ILECs were always compensated at less than their forward-looking costs

because, “[e]ven if actual . . . investment decisions were always com-

pletely efficient at the time they were made, improvements in technology

will always guarantee that a totally new, hypothetical, network will have

a theoretical lower cost than the actual network in place (or otherwise the

older technology could be used in the hypothetical network).” GTE

Comments, Hausman Aff. ¥ 14 n.4, CC Dkt. No. 96-98 (May 16, 1996)

(emphasis in original); see also id. ¥ 3 (“Technological change will de-

prive LECs of recovering costs if rates are always measured on the basis

of a forward-looking optimal network model.”); GTE Comments, Cran-

dall Decl. ff 15-16, CC Dkt. No. 96-98 (May 16, 1996) (“There are sim-

ply no market analogues for [the FCC’s proposed model]... . Unfortu-

nately, there is simply no evidence that such hypothetical networks would

represent an efficient use of society's resources. If this were not the case,

someone would be building them.”) (emphasis in original).

8

necessary and impair standard requires it to consider whether

a new entrant could obtain the requested element from a

source other than the incumbent. /d. at 296-97, 299-300 (Or-

der 47 283, 287). The order declared that any increase in cost

or decrease in quality, no matter how trivial, would satisfy

the impairment standard, on the ground that “requiring new

entrants to duplicate unnecessarily even a part of the incum-

bent’s network could generate delay and higher costs for new

entrants, and thereby impede entry by competing local pro-

viders and delay competition, contrary to the goals of the

1996 Act.” Id. at 296-97, 298 (Order 4] 283, 285) (emphasis

added). “The 1996 Act ... does not impose any limitations

on carriers’ ability to obtain access to unbundled network

elements.” /d. at 312-13 (Order { 329) (emphasis added).

The order then turned to the pricing of UNEs. It adhered

to the FCC’s proposal to base UNE rates on the theoretical

forward-looking costs of an idealized hypothetical competi-

tor. See J.A. 375-76, 397-401 (Order #{ 672-73, 704-07).

Notwithstanding the criticisms voiced in the comments, the

agency essentially adopted the same model it had proposed.

The FCC “coin{ed]” a new term, Total Element Long-Run

Incremental Cost (“TELRIC”), for a model that purported to

gauge the LRIC of network elements, rather tha. services.”

See id. at 378-79 (Order { 678).

The TELRIC methodology is expressly based on the

“use of the most efficient telecommunications technology

currently available and the lowest cost network configura-

tion.” 47 C.F.R. § 51.505(b)(1); see also J.A. 382-84, 386-

87 (Order 44 683-85, 690). In other words, by imagining a

period “long enough so that all of a firm’s costs become vari-

: The FCC made this change on the assumption that elements are

likely to have fewer joint and common costs than services. See. J.A.378-

79 (Order 4 678). The order nevertheless acknowledges that incumbents

still will have joint and common costs and that states may permit such

costs to be recovered in UNE prices. See id. at 389-90 (Order 4 695).

9

able or avoidable,” id. at 387, 397 (Order Ff 677, 692), the

model seeks to determine what a most efficient, least-cost

network would look like if it were reconstructed from scratch

at the time when UNE prices are being set, and then hypothe-

sizing what the costs of that network would be. See lowa

Utils. Bd., 525 U.S. at 374 n.3 (“TELRIC pricing is based

upon the cost of operating a hypothetical network built with

the most efficient technology available”). UNE prices are to

reflect this idealized network’s imagined costs.

The FCC acknowledged that a TELRIC methodology

would “discourage facilities-based competition by new en-

trants because new entrants can use the incumbent LEC’s

existing network based on the cost of a hypothetical least-

cost, most efficient network” and therefore would have

sharply reduced incentives to build their own facilities. J.A.

382-83 (Order { 683). The FCC’s only palliative was to al-

low the inclusion of one real-world factor: regulators would

“assume that wire centers will be placed at the incumbent

LEC’s current wire center locations.”’ Id. at 383-84 (Order

4 685). The FCC’s methodology ignores the actual location

of all the other facilities in an ILEC’s network and instead

reconstructs the network based on the theoretically ideal lo-

cations for such facilities. The FCC said that its considera-

tion of actual wire center locations would “encourage[] facili-

ties-based competition to the extent that new entrants, by de-

signing more efficient network configurations, are able to

provide the service at a lower cost than the incumbent LEC.”

Id. The FCC did not explain why the same rationale does not

apply to the locations of ILEC network facilities other than

wire centers — that is, why CLECs should be encouraged to

invest in facilities only when they can locate wire centers

more efficiently than the incumbent has and not when they

can locate other parts of the network more efficiently. Nor

3 A wire center is the physical location where subscriber lines connect -

to a switch.

10

did the FCC explain why its rationale does not apply when

CLECs could employ more efficient technologies than the

incumbent.

The agency did recognize that it could have based for-

ward-looking costs “on incumbent LECs’ existing network

infrastructures, taking into account changes in depreciation

and inflation.” J.A. 382-83 (Order FJ 683-84). But the

agency rejected that approach in a single sentence, labeling it

“essentially an embedded cost methodology.” /d.

D. Subsequent Proceedings

Incumbent LECs and state commissions sought review

of the order in the Eighth Circuit. That court held that the

FCC lacked jurisdiction to adopt pricing rules, and it accord-

ingly did not reach the merits of those rules. See lowa Utils.

Bd. v. AT&T, 120 F.3d 753, 800 (8th Cir. 1997). This Court

reversed, holding “that the Commission has jurisdiction to

design a pricing methodology.” Jowa Utils. Bd., 525 U.S. at

385.

This Court also rejected the FCC’s conclusion that the

necessary and impair standard imposes no limitations on a

carrier’s ability to obtain access to unbundled network ele-

ments. See id. at 387-91. The FCC’s error in reading the

standard sprang from its mistaken understanding that the Act

empowers it to assume the existence of a perfectly competi-

tive market for telecommunications services, an assumption

similar to the theoretical perfection that underlies TELRIC.

“In a world of perfect competition, in which all carriers are

providing their service at marginal cost, the Commission’s

total equating of increased cost (or decreased quality) with

‘necessity’ and ‘impairment’ might be reasonable; but it has

not established the existence of such an ideal world.” Id. at

390 (emphasis added). Congress could have written lan-

guage authorizing “blanket access to incumbents’ networks,”

but did not, and the FCC could not make up for the omission

by importing perfect competition assumptions found no-

where in the statute.* Id.

On remand, the court of appeals for the first time ad-

dressed the merits of TELRIC pricing. It upheld the FCC’s

decision to base prices on forward-looking rather than his-

torical costs and rejected as unripe the takings challenge by

ILECs to that decision. See Pet. App. 10a-18a. The court

agreed with the FCC that the “the term ‘cost,’ as it is used in

the statute [was] ambiguous,” and it deferred to the FCC’s

choice of forward-looking costs. /d. at |la-12a. But the

court rejected the FCC’s particular forward-looking cost ap-

proach. The court concluded that TELRIC, by completely

divorcing the prices that an ILEC may charge for UNEs from

the ILEC’s costs of providing the elements, was directly con-

trary to the Act. The court ruled that UNE prices must in-

stead be based on an ILEC’s own forward-looking costs:

Costs can be forward-looking in that they can be

calculated to reflect what it will cost the [LEC in the

future to furnish to the competitor those portions or

capacities of the ILEC’s facilities and equipment

that the competitor will use including any system or

component upgrading that the ILEC chooses to put

in place for its own more efficient use. ... At bot-

tom . . . Congress has made it clear that it is the cost

of providing the actual facilities and equipment that

will be used by the competitor (and not some state

of the art presently available technology ideally con-

figured but neither deployed by the ILEC nor to be

used by the competitor) which must be ascertained

and determined.

4 The FCC issued a new order interpreting the “necessary and impair”

standard on remand. I/mplementation of the Local Competition Provi-

sions of the Telecommunications Act of 1996, Third Report and Order, 15

FCC Red 3696 (rel. Nov. 5, 1999) (“UNE Remand Order’). That order is

under review yet again in the court of appeals. See United States Telecom

Ass'n v. FCC, Nos. 00-1015 & 00-1025 (D.C. Cir.).

12

Id. at 9a-10a.

As a result, while leaving intact much of the FCC’s pric-

ing regime, the court of appeals vacated the particular rule

requiring that prices be based, not on the ILEC’s costs, but

on the costs that a hypothetical carrier would incur through

“use of the most efficient telecommunications technology

currently available and the lowest cost network configura-

tion.” See id. at 10a (vacating 47 C.F.R. § 51.505(b)(1)).

Several incumbents sought review of the court of ap-

peals’ rejection of historical costs. The FCC and a number of

CLECs petitioned for certiorari to review the court’s decision

vacating the agency’s rule basing UNE prices on a hypotheti-

cal most efficient network. This Court granted certiorari on

both sets of pricing issues.” Qwest respectfully submits that

the decision of the court of appeals to vacate the FCC’s pric-

ing rule should be affirmed.

SUMMARY OF ARGUMENT

The FCC’s TELRIC methodology is inconsistent with

the 1996 Act and arbitrary and capricious. The Act requires

that UNE prices be based on the costs that an JLEC incurs in

“providing” an element. The FCC instead based UNE rates

on the costs that a hypothetical carrier would incur in using

an ideally efficient network that never will exist and that the

ILEC never will use to provide any element. Rather than fos-

ter the development of an actual competitive process, the

FCC’s order prescribes prices that correspond to the agency’s

guess at what the end result might be in a theoretical world of

perfect competition and instantaneous deployment of new

> The Court also granted the FCC’s petition for certiorari to review

the lower court’s ruling on rules concerning the conditions under which

ILECs could be required to combine UNEs. Qwest joins the separate

Respondents’ brief on that issue. See Brief for Respondents Verizon En-

tities, BellSouth Corp., SBC Communications, Inc., and United States

Telecom Association (June 8, 2001).

13

technologies. This approach could not be more at odds with

the language of the Act or its deregulatory purposes. It em-

bodies the same error that this Court found infected the

agency’s reading of the “necessary and impair” test for un-

bundling: even if the FCC’s reading might be reasonable

“{iJn a world of perfect competition . . . it has not established

the existence of such an ideal world.” Jowa Utils. Bd., 525

U.S. at 390. The FCC’s ideal world is divorced from the ac-

tual market context in which carriers compete. It lowers

prices without any corresponding decrease in costs and

thereby distorts market signals and discourages investment in

network facilities, contrary to the goals of the Act.

The FCC’s methodology also is arbitrary and capricious

on its own terms. The assumptions embodied in TELRIC

about how a real-world competitive market works are simply

wrong, especially where, as in the telecommunications sec-

tor, the market is capital-intensive and characterized by fre-

quent cycles of innovation and declining costs. Carriers do

not instantly and ubiquitously replace their network facilities

every time a more efficient technology becomes available,

nor do they immediately reduce their prices to the incre-

mental costs of the new network. Instead, building a network

is an iterative process. A carrier adjusts the capacity and lo-

cation of network facilities as customer populations shift and

grow, and it invests in new facilities only when the gap be-

tween prevailing prices and the costs of the new technology

becomes sufficiently great to allow the carrier to price be-

tween those two levels and expect to earn a return on its in-

vestment. The utter failure of TELRIC to mimic the opera-

tion of a market explains why the FCC is unable to point to

any instance in which such a methodology has been used to

set prices in similar circumstances. The end result of the

FCC’s methodology is to ensure that the incumbent has no

chance to recover its costs of providing network elements —

a result in direct contravention of the Act.

14

Contrary to the suggestion by petitioners, rejection of the

TELRIC model by no means requires the conclusion that the

term “cost” has a “single meaning” or that the FCC lacks dis-

cretion in establishing pricing guidelines for UNEs. In place

of the one rule vacated by the court of appeals, the FCC

could use the “historical cost” model championed by Verizon

or a model based in whole or part on forward-looking costs.

But the court below properly concluded that the agency does

not have discretion to adopt a methodology such as TELRIC

that eschews the incumbent’s costs altogether in favor of the

agency’s hypothesis of the costs of a nonexistent network

built to serve perfectly estimated demand in the most effi-

cient way conceivable with available technologies. That

methodology is contrary to the statutory text and its animat-

ing purposes and is arbitrary and capricious.

ARGUMENT

I. TELRIC IS FLATLY INCONSISTENT WITH THE

TEXT OF THE STATUTE.

Section 252(d)(1) provides that UNE rates “shall be. . .

based on the cost (determined without reference to a rate-of-

return or other rate-based proceeding) of providing the ...

network element,” shall be “just and reasonable,” and “may

include a reasonable profit.” 47 U.S.C. § 252(d)(1). These

provisions require that UNE prices be based on the costs that

an ILEC will incur in providing a particular element. While

the Act does not mandate a single methodology for determin-

ing those costs, it does limit the FCC’s discretion by forging

a relationship between the price an ILEC may charge for a

UNE and the costs that the JLEC incurs in providing the

UNE. TELRIC severs that relationship, and links UNE

prices instead to the costs that would be incurred by a hypo-

thetical competitor using “the most efficient telecommunica-

tions technology currently available and the lowest cost net-

work configuration.” 47 C.F.R. § 51.505(b)(1). The Eighth

Circuit correctly vacated this rule as inconsistent with the

15

text of section 252(d)(1), and this Court should affirm. See,

e.g., United States v. Wells, 519 U.S. 482, 490 (1997) (natu-

ral reading of the full text is the “first criterion in the

interpretive hierarchy” for statutes); Connecticut Nat’l Bank

v. Germain, 503 U.S. 249, 253-54 (1992) (“[C]ourts must

presume that a legislature says in a statute what it means and

means in a statute what it says there.”’).

Section 252(d)(1) requires that UNE rates be “based on

the cost . . . of providing the ... network element.” 47

U.S.C. § 252(d)(1) (emphasis added).° The FCC and its sup-

porters focus on the term “cost” in isolation and assert that

the ambiguity of that term gives the FCC virtually carte

blanche discretion. See FCC Pet. Br. at 27-28; AT&T Pet.

Br. at 29; WorldCom Pet. Br. at 25-26. But even assuming

that “cost” itself may have different meanings, this does not

imply that the term imposes no constraints at all, and the rest

of the words in the statutory directive preclude the FCC’s

choice of TELRIC. First, by mandating that UNE rates be

“based on the cost . . . of providing” an element, Congress

directed the FCC to choose a methodology that measures the

costs that the ILEC — which is doing the providing — incurs

in providing elements. TELRIC, by contrast, bases UNE

prices on the costs that a hypothetical carrier would theoreti-

cally incur in providing the element’s functions over an

imaginary network that uses only the most efficient technol-

ogy and network layout available at all times. See, e.g., J.A.

382-84 (Order {J 683-85). Since those hypothetical costs

will never correspond to (and, indeed, will always be lower

than) the costs that the ILEC incurs in providing the element,

TELRIC does not produce a price “based on the cost . . . of

providing” the UNE.

® As the FCC has noted, the parenthetical term “determined without

reference to a rate-of-return or other rate-based proceeding” does not “de-

fine the type of costs that may be considered, but rather specifies a type

of proceeding that may not be employed.” J.A. 397-98 (Order J 704).

16

Second, as the court of appeals concluded below, by

linking UNE prices to the cost of providing “the . . . network

element,” the statute focuses on the actual element or func-

tionality that will be provided. See Pet. App. 7a-9a.’ If Con-

gress had intended UNE rates to reflect the costs of a hypo-

thetical UNE that might be provided by a nonexistent carrier

in a market where prices instantly reflect the most efficient

technology available, it could have, and would have, used

language to that effect. But Congress did not do so, and the

FCC is not empowered to treat the statute as though it had.

The legislative history of section 252(d)(1) confirms that

Congress intended UNE prices to correspond to the costs of

the providing ILEC, not the costs of a hypothetical competi-

tor. The House bill specified a pricing standard “requir[ing]

that the costs that a carrier incurs in offering . . . unbundled

...@lements . . . shall be borne by the users of such . . . ele-

ments.” H.R. Rep. No. 104-204, at 4 (1995) (emphasis

added). The Senate Report likewise noted that the UNE pric-

ing provision (then enumerated section 251(d)) “provides

that any charge determined by the State through arbitration or

intervention shall be based on the cost of that unbundled

element and may include a reasonable profit.” S. Rep. No.

104-23, at 21 (1995) (emphasis added). This language rein-

forces the text of the statute: section 252(d)(1) ties rates for a

given element to the costs not of some hypothetical alterna-

tive, but of that element, in the actual context in which the

ILEC will provide it. TELRIC ignores this clear congres-

sional mandate.

Congress’s intention that UNE prices relate to an ILEC’s

costs is further corroborated by the terms that Congress used

7 ‘This does not mean, as WorldCom suggests, that a unique price

must be assigned to every individual switch or loop. See WorldCom Pet.

Br. at 27-28. A regulator may choose to set a single average price for

loops, or for loops within a particular geographic area, but that price must

be based on the costs that the incumbent will incur in providing its loops.

17

elsewhere in section 252(d)(1). The statute directs that rates

“may include a reasonable profit.” Although this language

gives regulators some discretion to decide whether or not to

include a profit, they could not even consider the question

unless the ratesetting mechanism took account of the ILEC’s

actua! investments and expenditures. Time and again, courts,

economists, and other authorities have construed the term

“profit” to refer to the amount by which an entity’s returns

exceed its costs. See, e.g., California Dental Ass'n v. FTC,

526 U.S. 756, 767 n.6 (1999) (“[A]ccording to a generally

accepted definition ‘profit’ means gain from business or in-

vestment over and above expenditures, or gain made on busi-

ness or investment where both receipts or payments are taken

into account.”) (internal quotations omitted); Steven E.

Landsburg, Price Theory and Applications 782 (3d ed. 1995)

(defining “profit” as “(t]he amount by which revenue exceeds

costs”); Black’s Law Dictionary 1211 (6th ed. 1990) (defin-

ing profit as the “[g]ain realized from business or investment

over and above expenditures”). Indeed, the FCC’s order here

acknowledges that, “in plain English, profit is defined as ‘the

excess of returns over expenditure in a transaction or series

of transactions.” J.A. 393 (Order { 699).*

By directing regulators to consider whether to include a

“profit,” Congress voiced its expectation that a UNE rate

would be set based on an JLEC’s costs. TELRIC forecloses

any potential for profit by setting UNE prices such that the

ILEC has no chance to recoup its costs, even of future in-

vestments, except at a hypothetical instant at which every

8 The FCC attempted to reconcile this definition of profit with its

TELRIC standard by stating conclusorily that “[p)ossible accounting

losses from the sale of . . . unbundled network elements using a reason-

able forward-looking cost-based methodology do not necessarily indicate

that incumbent LECs are being denied a ‘reasonable profit’ under the

statute.” J.A. 395 (Order 4701). That assertion does not explain how a

methodology that disregards everything about an incumbent’s actual net-

work can measure the incumbent's costs or, a fortiori, its return in excess

of costs.

18

component of its facilities is the most efficient component

available. See, e.g.,GTE Comments, Hausman Aff. {| 14. As

discussed more fully below, see Part III, infra, that instant

never will arrive in practice for any ILEC; and if it did, prices

and costs would immediately diverge again as further techno-

logical advancements are reflected in lower UNE prices,

even though neither the ILEC nor any competitor had im-

plemented those advancements in its network.

Il. THE FCC’S METHODOLOGY IS NOT DEREGU-

LATORY, CREATES ARTIFICIAL INCENTIVES,

AND DISCOURAGES INVESTMENT, ALL IN

DIRECT CONTRAVENTION OF THE ACT’S

PURPOSES AND POLICY.

The FCC’s TELRIC methodology also thwarts the Act’s

purposes and “frustrate[s] the policy that Congress sought to

implement.” Securities Indus. Ass’n v. Board of Governors

of the Fed. Reserve Sys., 468 U.S. 137, 143 (1984) (internal

quotations omitted); see also John Hancock Mut. Life Ins.

9 ‘The statute's requirement that UNE rates be “just and reasonable”

further cements the link between UNE rates and the ILEC’s costs. Fed-

eral courts, including this Court, routinely have held that, to be “just and

reasonable,” rates must at least “enable the company to operate success-

fully, to maintain its financial integrity, to attract capital, and to compen-

Sate its investors for the risks assumed.” FPC v. Hope Natural Gas Co.,

320 U.S. 591, 605 (1944); see also Wisconsin v. FPC, 303 F.2d 380, 388

(D.C. Cir. 1962) (“It is established by tradition and by many court deci-

sions that for a public utility, rendering service by use of fixed equipment,

a just and reasonable rate is one which returns a fair profit upon the in-

vestment, or which supplies the utility with adequate revenues to com-

mand needed funds upon an economically reasonable basis.”), aff'd, 373

U.S. 294 (1963). By choosing a methodology that ensures ILECs will

never recover their costs, the FCC has violated the settled meaning of the

requirement that UNE prices be “just and reasonable.” Neder v. United

States, 527 U.S. 1, 21 (1999) (“[W]here Congress uses terms that have

accumulated settled meaning under the common law, a court must infer,

unless the statute otherwise dictates, that Congress means to incorporate

the established meaning of these terms.”) (internal quotation marks omit-

ted).

19

Co. v. Harris Trust & Sav. Bank, 510 U.S. 86, 94-95 (1993)

(agency construction must be consistent with statute’s “ob-

ject and policy”). Congress intended to deregulate local tele-

communications and rely on market forces to encourage all

participants to invest and innovate. Rather than encourage

the development of an actual competitive process, the FCC

prescribed prices it guessed would prevail in a perfectly

competitive market in a theoretical world. In so doing, the

FCC abandoned the deregulatory goals of the Act in favor of

just another form of regulation that distorts the marketplace

by deterring investment and facilities-based competition.

Congress intended sections 251 and 252 to serve the

Act’s objective of fostering a competitive marketplace. UJ-

timately, the statute is deregulatory in nature: Congress’s

objective was to create a competitive marketplace so that

market forces would drive decisions about entry, investment,

and pricing. See, e.g., Conf. Rep. at 113 (Act creates a “de-

regulatory national policy framework”); J.A. 265 (Order { 3)

(Act is “deregulatory”). As the order itself observes, by pass-

ing the Act, Congress intended to “look to the market, not to

regulation, for the answer.” Id. at 271-72 (Order { 12).

A critical part of Congress’s deregulatory vision was to

encourage investment in new facilities and technologies. As

the FCC itself has recognized, a “fundamental goal of the Act

is to promote investment and innovation by all participants in

the telecommunications marketplace, and, in particular, to

encourage rapid deployment of new telecommunications

technologies.” UNE Remand Order, 15 FCC Rcd at 3748,

4 110. Congress broadly mandated that “[t]he Commission

and each State commission with regulatory jurisdiction over

telecommunications services shall encourage the deployment

on a reasonable and timely basis of advanced telecommuni-

cations capability to all Americans” and “take immediate ac-

tion to accelerate deployment of such capability by removing

barriers to infrastructure investment.” 47 U.S.C. § 157 note.

20

Congress believed that such infrastructure investment

would lead to facilities-based competition in the local tele-

communications market. The premise of the Act is that local

telephone service is not a natural monopoly and that facili-

ties-based competition is therefore both possible and desir-

able. See Iowa Utils Bd., 525 U.S. at 371; Conf. Rep. at 148

(endorsing view that “meaningful facilities-based competi-

tion is possible”).'° Indeed, facilities-based competition is

clearly preferable to competition based on UNEs:

“(C]ompetition [is] increased by encouraging [firms] to [de-

velop rival facilities], rather than taking the easier and less

competitive course of obtaining access to another’s facili-

ties.” 3A Philip E. Areeda & Herbert Hovenkamp, Antitrust

Law 4 773b2, at 203-04 (1996). As Justice Breyer observed,

“[i}t is in the unshared, not in the shared, portions of the en-

terprise that meaningful competition would likely emerge.”

Iowa Utils. Bd., 525 U.S. at 429 (Breyer, J., concurring in

part and dissenting in part) (emphasis in original). Although

the Act may not require the FCC to favor facilities-based

competition over UNEs (and resale), at a minimum it re-

quires that the FCC not erect artificial disincentives to that

strategy. J.A. 271-72 (Order J 12) (“Section 251 neither ex-

plicitly nor implicitly expresses a preference for one particu-

lar entry strategy.’’).

10 See also Conf. Rep. at | (passage of the Act would “accelerate rap-

idly private sector deployment of advanced telecommunications and in-

formation technologies”); Communications Law Reform: Hearings Be-

fore the Subcomm. on Telecommunications and Finance of the House

Comm. on Commerce, 104th Cong. 9 (1995) (the Act “rightly stresses a

need for facilities-based competitors to lead the way in providing a true

alternative to today’s monopoly in the local exchange service. In fact, it

is no exaggeration to say that the entire bill is premised on the existence

of robust facilities-based competitors.”) (statement of Rep. Schaefer); 141

Cong. Rec. 22,040 (1995) (the Act is intended to “give[{] new entrants the

incentive to build their own local facilities-based networks, rather than ~

simply repackaging and reselling the local services of the local telephone

company”) (statement of Rep. Goodlatte).

21

A. The FCC’s Order Distorts Entry and Investment

Incentives by Relying on Regulation Rather than

the Marketplace.

The FCC’s order defeats Congress’s goal of fostering a

deregulated competitive marketplace in which entry and in-

vestment decisions are based on market signals. Instead, the

order uses regulation to simulate a theoretically perfect mar-

ket through regulation — that is, it prescribes rates at levels

that the agency theorized would prevail in a nonexistent, per-

fectly competitive market without regard to whether its ac-

tions would encourage or impede the development of a com-

petitive process. J.A. 379-80 (Order 4 679). As Justice

Breyer explained in Jowa Utilities Board, such an approach

— far from deregulatory — simply substitutes one form of

regulation for another: “[t}he competition that the Act seeks

is a process, not an end result; and a regulatory system that

imposes through administrative mandate a set of prices that

tries to mimic those that competition would have set does not

thereby become any less a regulatory process, nor any the

more a competitive one.”'' Jowa Utils. Bd., 525 U.S. at 424

'! ‘The FCC itself recognized this very distinction in an order released

less than a year after the order at issue here. The agency rejected calls by

carriers such as AT&T and WorldCom to prescribe the level of access

charges (charges paid by long distance carriers to LECs to originate and

terminate long distance calls) on the basis of forward-looking costs:

We decide that adopting a primarily market-based approach to

reforming access charges will better serve the public interest

than attempting immediately to prescribe new rates for all in-

terstate access services based on the long-run incremental cost

or forward-looking incremental cost of interstate access ser-

vices. Competitive mark. ° are superior mechanisms for pro-

tecting consumers by ensuring that goods and services are pro-

vided to consumers in the most efficient manner possible and

at prices that reflect the cost of production. . . . In addition, us-

ing a market-based approach should minimize the potential

that regulation will create and maintain distortions in the

22

(Breyer, J., concurring in part and dissenting in part). In-

deed, because the FCC’s TELRIC methodology discourages

investment in network facilities, see infra Part II.B, its meth-

odology actually is a barrier to the development of a real

competitive marketplace.

In setting UNE prices based on the assumption of a theo-

retically perfect market, the FCC committed much the same

error that infected its determination that the statutory “im-

pair” test was met by any increase in cost. See J.A. 292 (Or-

der { 285). As this Court explained in reversing that deter-

mination, “[iJn a world of perfect competition, in which all

carriers are providing their service at marginal cost, the

Commission’s total equating of increased cost . . . with ‘ne-

cessity’ and ‘impairment’ might be reasonable; but it has not

established the existence of such an ideal world.” lowa

Utils. Bd., 525 U.S. at 390 (emphasis added). Likewise here,

although UNE prices might tend toward some measure of

incremental costs in a world of perfect competition, that is

not this world. See James C. Bonbright, Albert L. Danielsen

& David R. Kamerschen, Principles of Public Utility Rates

146 (2d ed. 1988) (“Public Utility Rates”) (“[T]}he concept of

perfect competition makes no sense whatsoever” as a pricing

standard. ).

Finally, the FCC’s methodology makes a nullity of the

voluntary negotiation provisions of the Act. The statute al-

lows carriers to engage in good-faith, private negotiations

“without regard” to the Act's requirements, including the

provision concerning pricing of UNEs. 47 U.S.C.

§§ 251(c\(1), 252(a)(1), 252(e 2A). Only if the parties

cannot reach agreement may regulators set UNE prices. See

id. § 252(b). But negotiations over UNE rates under these

investment decisions of competitors as they enter local tele-

communications markets.

Access Charge Reform, First Report and Order, 12 FCC Red 15,982,

16,094, | 263 (rel. May 16, 1997).

23

provisions are meaningless where the default price is set

based on a hypothetical, idealized network and below any

real-world price, as TELRIC mandates.

B. The Order Creates Disincentives to Investment

by Both CLECs and ILECs.

The FCC’s attempt to simulate a perfectly competitive

market rather than foster an actual competitive process dis-

torts market signals and suppresses the level of investment

and innovation by ILECs and CLECs alike in direct contra-

vention of Congress's intent.

1. In the case of CLECs, TELRIC discourages invest-

ment in at least three ways:

First, the methodology reduces the incentive of CLECs

to invest, because, no matter how efficient, they by definition

will never be able to invest at costs lower than the idealized

TELRIC price for UNEs. Indeed, the order makes explicit

that UNE prices should never exceed and “in most cases”

will be below “the forward-looking cost that an efficient en-

trant would incur in providing a given element.” J.A. 392

(Order { 698); see also Alfred E. Kahn, Letting Go: Deregu-

lating the Process of Deregulation 101 (1998) (“Letting Go”)

(“What is the point of a CLEC constructing its own facilities

if it can lease or purchase them from the incumbent compa-

nies at the theoretically estimated minimum cost (let alone

below that cost [as under TELRIC}) that would be incurred

by a new entrant building from the ground up?”).

The FCC’s order gives CLECs the pricing benefits of

cost-saving innovations where those innovations have not

been implemented and costs have not actually declined. This

mismatch between prices and costs distorts market signals

and creates disincentives to the investment in facilities that

actually would drive costs down to an efficient level:

The economic purpose of prices set at incremental

cost is to inform buyers — and make them pay —

24

the cost that society will actually incur if they pur-

chase more or would actually save if they reduced

their purchases, entirely or partially. These can only

be the costs of the supplier whose prices are being

set, not some hypothetical ideal producer. More-

over, such prices give challengers the proper target

at which to shoot — the proper standard to meet or

beat and the proper reward if they succeed. If they

can achieve costs lower than that, they will enter

and in the process (which the FCC’s pricing rules

would omnisciently short-circuit) beat prices down

to efficient levels. In contrast, TELRIC-based

charges — if the FCC’s apparent expectation that

such rates would be lower than rates based on tele-

phone companies’ actual costs is correct — would

actually discourage competitors coming in and

building their own facilities . . . .

Alfred E. Kahn, Timothy Tardiff & Dennis L. Weisman, The

Telecommunications Act at three years: an economic

evaluation of its implementation by the Federal Communica-

tions Commission, 11 Info. Econ. & Pol’y 319, 330 (1999)

(“Economic Evaluation”) (emphasis in original).'?

'2 This same mismatch of prices and costs explains the infirmity of

petitioners’ suggestion that failure to price elements at TELRIC will per-

mit incumbents to engage in a “price squeeze.” See WorldCom Pet. Br.

at 11, 40; AT&T Pet. Br. at 18, 32. According to petitioners, if CLECs

must buy UNEs at prices above TELRIC, they will have to price their

services above TELRIC prices in order to recover their full costs. In the

meantime, petitioners posit, incumbents will price their services at TEL-

RIC and therefore will be able to squeeze the CLECs out of the market.

See WorldCom Pet. Br. at 11. But this argument assumes that carriers are

operating in a perfectly competitive market in which prices are at mar-

ginal costs and that the incumbent or some other seller is an ideally effi-

cient carrier whose costs actually equal TELRIC. Of course, that is not

the case. As long as the CLEC obtains an element from the ILEC at or

below the ILEC’s costs (as opposed to the TELRIC costs of a hypotheti-

cal competitor), there is no possibility of a price squeeze: both the CLEC

and the ILEC must recover the same costs for that element in the retail

25

The order’s uncoupling of UNE prices from costs is evi-

dent also in its faulty analysis of a CLEC’s entry decision.

The FCC states that its methodology focuses on “factors

relevant to any carrier’s present choices in a competitive

market with respect to entry, expansion, and pricing.” FCC

Pet. Br. at 21. The agency observes that, all other things be-

ing equal, if a more efficient and less costly facility is avail-

able as a substitute for an incumbent’s element, a rational

entrant will not pay more than the cost of that substitute facil-

ity for the element. See id. at 22-23, 29. But the FCC fol- -

lows with a non sequitur: that the price for the incumbent's

less efficient element should be set at the cost of the more

efficient substitute, since that is all a rational entrant would

pay. Of course, if in fact a more efficient alternative facility

is available, CLEC investment in that facility — and not pur-

chase of the less efficient incumbent UNE at an artificially

low price — will promote the development of competition.

The FCC’s methodology, however, strongly discourages

such an investment from being made.

Second, TELRIC deters investment in facilities because

investing in current technology exposes a CLEC to the very

real risk that the mere availability of a still newer technology

will instantaneously be reflected in the incumbent’s UNE

prices and put its own facilities at a competitive disadvantage

as compared to CLECs relying on UNEs. To the extent that

a CLEC does consider investing to install even today’s most

efficient technology, the CLEC (like the incumbent) will re-

alize that it would be unable to recoup the investment, be-

cause the prices of the incumbent’s UNEs would immedi-

price for the service. Indeed, if anything, TELRIC pricing puts /LECs in

a price squeeze. Because a CLEC can obtain an element (or indeed, un-

der the FCC’s order, all the elements needed to provide a service) at the

costs that would be incurred by an ideally efficient competitor, the CLEC

can price below the costs of the ILEC, who — as petitioners insist, see

FCC Pet. Br. at 28-29; AT&T Pet. Br. at 4, 18, 19, 33 — is not ideally

efficient.

26

ately reflect tomorrow’s further innovations, even if nobody

had invested to install them. Of course, a competitor in a

capital-intensive market with rapidly evolving technologies

and declining costs always must weigh the risk of obsoles-

cence against the potential gain in efficiency that investing in

the current technology may bring. But, under TELRIC,

CLECs can gain the benefit while entirely avoiding the risk

of obsolescence by relying on UNEs and the automatic re-

duction of UNE prices to reflect every technological ad-

vance. In so doing, the CLEC purchasing UNEs will obtain

an artificial regulatory advantage over a CLEC that invests in

its own facilities.

Third, TELRIC pricing discourages CLEC investment

because it artificially expands the list of UNEs to encompass

facilities the CLEC could self-provision or obtain from third

parties at costs that, while above TELRIC, are lower than the

incumbent’s costs. As originally written, the FCC’s order

deemed the statutory “impair” test to be satisfied by any in-

crease in cost that the CLEC would incur if it did not have

access to the element in question. J.A. 292 ({ 285). Not sur-

prisingly, having defined the price of a element to be equal to

the cost that a hypothetical, ideally efficient carrier would

incur, the FCC found this test to be satisfied by every ele-

ment it examined. In Jowa Utilities Board, this Court held

that the FCC’s interpretation drained the “impair” test of any

substance and accordingly directed the FCC to impose a ra-

tional limiting standard. 525 U.S. at 387-91. On remand, the

FCC has indicated that the impair test is met when there is a

“material” difference in cost. See UNE Remand Order at

3725,451. Whatever that may mean, it is clear that, because

UNEs are priced at the incremental cost of an ideally effi-

cient competitor, self-provisioning (or obtaining elements

from third parties) will be “materially” more costly than un-

bundling even in situations where the CLEC could build or

27

obtain an element more efficiently than the ILEC."® And

once that element is made available for unbundling, the

CLEC will have little incentive to self-provision instead of

leasing the element from the incumbent at the cost of an ide-

ally efficient carrier it could not hope to outcompete.'*

2. TELRIC pricing also undercuts incumbents’ incen-

tives to invest and innovate. As two prominent economists

have explained, “{uJnder the FCC’s TELRIC price regula-

tion, if a new service is successful, a competitor can buy the

service at its total . . . long-run incremental cost .... Fora

successful new service, the ILEC recovers at most its cost.

For unsuccessful services, the ILEC recovers nothing and

loses its sunk investment.” Jerry A. Hausman & J. Gregory

Sidak, A Consumer-Welfare Approach to the Mandatory Un-

bundling of Telecommunications Networks, 109 Yale L.J.

417, 459-60 (1999). As a result, “the expected return to the

ILEC [for research and development costs] would always be

negative,” and “regulation would completely eliminate the

economic incentive to provide the new service.” Id.; see also

lowa Utils. Bd., 525 U.S. at 429 (Breyer, J., concurring in

part and dissenting in part) (“Nor can one guarantee that

firms will undertake the investment necessary to produce

complex technological innovations knowing that any com-

13 Indeed, with one exception, the FCC required unbundling of all the

same elements as in its original order and then expanded the list to in-

clude additional elements. See UNE Remand Order, 15 FCC Red 3696

(rel. Nov. 5, 1999), review pending, United States Telecom Ass'n v. FCC,

Nos. 00-1015 & 00-1025 (D.C. Cir.).

14 Of course, some CLECs have made substantial investments in facili-

ties. But, as facilities-based CLECs told the FCC on remand from this

Court, the FCC’s unbundling rules, including TELRIC, suppress the

amount of such investments. See, e.g., Cox Communications Comments

at 3, CC Dkt. No. 96-98 (May 26, 1999) (“A regulatory regime that fos-

ters the broad availability of incrementally priced UNEs discourages

competing carriers from building their own networks and leaves them

dependent over the long term on the ILECs, to the detriment of the public

interest.”’).

28

petitive advantage deriving from those innovations will be

dissipated by the sharing requirement.”); Economic Evalua-

tion at 347-49 (“The notion that the ILECs are likely . . . to

engage in . . . risky investments under a regulatory regime

that requires them immediately to share those facilities with

their competitors . . . at prices based on the FCC’s efficient-

firm cost standards is, quite simply, ludicrous.”).'°

In the end, even the FCC acknowledged the perverse in-

vestment incentives created by UNE prices based on a hypo-

thetical, ideally efficient network. It conceded that such

prices “discourage facilities-based competition by new en-

trants because new entrants can use the incumbent LEC’s

existing network based on the cost of a hypothetical least-

cost, most efficient network” and therefore have little incen-

tive to build their own facilities.- J.A. 382-84 (Order J 683).

The FCC’s “solution” was to make a single bow toward real-

ity by adjusting its methodology so that the locations of

incumbent’s wire centers would be held constant. See id. at

383-84 (Order 685). This, the FCC said, will give CLECs

an incentive to invest in facilities when and if they can use

more efficient wire center locations. See id.

But the FCC failed to recognize the significance of this

concession. It offered no explanation as to why it makes

sense to encourage a CLEC to invest when it can choose a

more efficient switch location than the ILEC, but not when it

can be more efficient than the ILEC in any other way,

whether by using a newer technology or by locating parts of

1S To be sure, incumbents may not be required to unbundle “proprie-

tary” elements unless the FCC finds access to such elements to be “neces-

sary.” 47 U.S.C. § 251(d)(2). However, many innovations and invest-

ments are not “proprictary” and, in any event, the FCC has already indi-

cated an intention to override the statutory “necessary” standard when-

ever it decides (based on entirely unspecified criteria) “that the incumbent

LEC’s asserted proprietary interest 1 2utweighed by the benefits of facili-

tating more rapid deployment of competition for the greatest number of

consumers.” UNE Remand Order at 3718-19, | 37.

29

its network other than switches more efficiently than the

ILEC. In point of fact, if a CLEC can build or locate any

network element more efficiently than the competing ILEC

has done, costs are reduced when the CLEC invests in that

element rather than continuing to rely on the less efficient

and more costly (even if favorably priced) ILEC element.

In sum, the FCC’s rule requiring UNE prices to be based

on the cost of a hypothetical, ideally efficient network cannot

be reconciled with the Act, because the rule contravenes

Congress’s goals of creating a deregulated competitive mar-

ketplace and encouraging investment in facilities by CLECs

and ILECs alike. Accordingly, the court of appeals’ decision

to vacate the rule should be affirmed.

lil. THE FCC’S METHODOLOGY IS ARBITRARY

AND CAPRICIOUS ON ITS OWN TERMS BE-

CAUSE IT IS BASED ON ERRONEOUS ASSUMP-

TIONS THAT DO NOT REFLECT HOW REAL-

~ WORLD MARKETS OPERATE.

The FCC’s TELRIC methodology is unlawful also be-

cause, although it purports to simulate the results of a com-

petitive market, TELRIC relies on unsupported and inaccu-

rate assumptions that fail to mimic how a real-world com-

petitive market operates. The FCC’s TELRIC methodology

assumes that, (1) as soon as a new cost-saving technology

becomes available, (2) a carrier will immediately install that

technology throughout its service region without regard to its

previously installed facilities, and (3) immediately reduce its

prices completely to its new lower incremental costs. None

of these assumptions holds in a competitive market, particu-

larly in one such as telecommunications that is capital inten-

sive and characterized by rapid technological change and de-

clining costs. By basing UNE prices on these flawed as-

sumptions, the FCC’s methodology ensures that the incum-

bent will forever be required to charge less than it invested in

its facilities and never will recover the costs of even new (let

alone historical) investments. See, e.g., GTE Comments,

30

Hausman Aff. { 14 n.4 (“[I]mprovements in technology will

always guarantee that a totally new, hypothetical, network

will have a theoretical lower cost than the actual network in

place.... Thus, basing cost on the current most efficient

technology will impart a downward bias on estimates of ac-

tual network costs, causing an economic loss to the

| > TR, *

“Available” Technologies. Requiring UNE prices to be

based on the most efficient technology that is “currently

available,” as TELRIC does, 47 C.F.R. § 51.505(b)(1), is

contrary to how prices are set in a competitive market. The

mere availability of a new technology, whether in a lab or

even in the channels of commerce, is not sufficient to drive

prices down in a real-world competitive marketplace. See J.

Gregory Sidak & Daniel F. Spulber, Givings, Takings and

the Fallacy of Forward-Looking Costs, 72 N.Y.U. L.J. 1068,

1142 (1997). Rather, a new technology affects prices only if

at least one competitor has installed it (or certainly will do so

in the near future) in sufficient quantities to supply a signifi-

cant portion of the relevant market. Even AT&T’s expert has

grudgingly conceded that “in a competitive market the avail-

ability of a small amount of less-costly improved equipment

does not immediately lead to an equivalent reduction in the

affected prices” and that the FCC’s TELRIC methodology

therefore may require some “readjustment.” William J.

Baumol & Thomas W. Merrill, Does the Constitution Re-

quire that We Kill the Competitive Goose? Pricing Local

Phone Services to Rivals, 73 N.Y.U. L. Rev. 1122, 1147

(1998); see also GTE Comments, Hausman Aff. { 14 n.4 (“In

a competitive market, a potential entrant could choose a new

technology, but if the potential entrant decides not to enter,

the hypothetical costs do not enter the pricing decisions,”

notwithstanding the availability of the new technology).

Ubiquitous and Immediate Deployment. The FCC’s

methodology also fails to reflect real-world markets because

it bases, and lowers, UNE prices on the erroneous assump-

ie

tion that carriers operate in a perpetual greenfield. No carrier

instantaneously installs a new network whenever a cost-

Saving innovation appears, as though it had no investment in

existing facilities. Rather, even when a carrier decides to in-

vest in a new technology, it generally does so incrementally,

not ubiquitously throughout its network. For example, a car-

rier may use a new, more efficient loop technology first to

extend service to a new neighborhood or development. But

to assume (as the FCC’s methodology does) that the carrier

will simultaneously replace all existing loops in its network

with the new technology belies reality. As Professor Kahn

explains, TELRIC .

assume[s] in effect that the ‘efficient firm’ simply

takes over the current volume of sales of the incum-

bent, sizing its plant to serve that demand at mini-

mum cost. This assumption ignores the fact that

many telecommunications assets are long-lived and

that capacity is not deployed all at once, overnight,

but expands incrementally to serve growing and

changing demand. Ignoring the dynamic character

of this process inherently understates the minimum

costs of serving demand as it materializes in the real

world, over time.

Economic Evaluation at 333-34; see also Baumol & Merrill,

73 N.Y.U. L. Rev. at 1147.

Firms systematically practice what economists term “an-

ticipatory retardation.” Rather than building a network from

scratch to incorporate the newest technology the moment it

becomes available, a firm invests in a new technology only

when and where the cost of that technology is sufficiently

below current prices that the firm can expect to earn a return

on its investment in new assets over their economic lives.

See, e.g., Economic Evaluation at 326. As a result, each car-

rier has capital plant of several vintages, with each vintage

becoming outmoded over time as technological innovations

permit lower costs. When the cost differential becomes suf-

32

ficiently great to justify making the investment needed to in-

stall a new technology in a particular location, the carrier

does so and thereby achieves a cost advantage over other car-

riers whose plants have vintages that are in varying degrees

less efficient than the new one.

Because no real-world carrier instantaneously installs a

new technology throughout its network, the FCC’s assump-

tion of ubiquity artificially lowers UNE prices. Under the

agency’s methodology, each time the network is recon-

structed to calculate UNE prices, the facilities hypothetically

deployed have the perfect amount of capacity and are in the

ideal locations given current and reasonably foreseeable de-

mand. In the real world, of course, even efficient carriers do

not have the benefit of such hindsight. They must project at

the outset how much capacity they will need and where; then,

if demand grows, they must increase capacity by, for exam-

ple, adding modules to an existing switch — typically less

efficient than buying a switch perfectly sized for the new

output. See Bell Atlantic Reply Comments, Epstein Decl.

q¥ 15 (TELRIC “imagines that in a competitive industry an

efficient firm makes all the correct decisions on cost and de-

sign for the optimal network the first time out of the box, and

has perfect foresight of how technology will develop. Stated

in this form, the proposal offers a parody and not a descrip-

tion of a competitive industry.”).

Moreover, the FCC’s methodology posits a “bulk pur-

chase” of the new facilities, when in fact carriers are likely to

buy and install a new technology in much smaller increments

with correspondingly higher costs (since they will not benefit

from the same volume discounts). Finally, even when a new

technology is installed, it lowers costs only in the particular

location where the installation occurs. The airline industry

illustrates this phenomenon. If a more efficient airline begins

service on a route — say, from Richmond to Atlanta — and

charges fares based on its lower costs, competitors may be

forced to meet that reduced fare on their Richmond to Atlanta

33

flights. They are not, however, forced to match that fare

throughout the rest of the country. Similarly, even in a fully

competitive telecommunications market, if a carrier rolls out

a new technology in a particular area, prices may begin to

drop in that area (though, as discussed below, they will not

fall to LRIC immediately), but not, as the FCC’s TELRIC

methodology assumes, everywhere at once.

Instantaneous Price Reduction. The FCC’s methodol-

ogy also erroneously assumes, again without explanation, the

existence of a theoretically perfect market in which prices

immediately reflect the full cost savings of a carrier’s invest-

meat in a new lower-cost technology. But the opposite is

true. A key incentive to install a new technology is to

achieve a temporary cost advantage over competitors. See,

e.g., Economic Evaluation at 348-49. As long as that cost

advantage persists, the investing carrier can price sufficiently

above its newly lowered costs to recoup its investment.

When another carrier invests in a still newer and lower cost

technology, the first carrier’s cost advantage dissipates, and

the second carrier achieves a cost advantage for a period of

time (again pricing somewhere between the first carrier’s

costs and its own). See, e.g., U S WEST Comments, Harris

& Yao Aff. at 19, CC Dkt. No. 96-98 (May 16, 1996)

(“[W]hat often occurs in competitive industries is that a pro-

duction facility makes above average profits during its early

years of operation, which decline over time until the firm is

forced to upgrade or close down the production facility.”).

As this cycle of leapfrogging investment goes forward, each

carrier has an opportunity to recoup its investments by pric-

ing above its incremental costs, and thus has an incentive to

invest. See, e.g., William J. Baumol, Janusz A. Ordover, &

Robert D. Willig, Parity Pricing and Its Critics: A Neces-

sary Condition for Efficiency in the Provision of Bottleneck

Services to Competitors, 14 Yale J. Reg. 145, 160 (1997)

(“[Flor each firm in a competitive market, the market price

will cover the incremental cost of its product, a competitive

return on the cost outlay, and a bonus exactly equal to any

34

relative cost savings that the efficiency of the firm permits it

to contribute.” (emphasis added)); see also Public Utility

Rates at 154-55."°

This cycle will tend to drive prices down over time in

response to cost-reducing innovations, but prices will not, as

the FCC’s methodology assumes, continuously drop all the

way to the costs of the most efficient installed technology,

particularly in an industry marked by rapid innovation cycles.

To the contrary, the ability to price above cost is a key in-

ducement to innovation and investment: Just as patent and

intellectual property laws recognize that exclusive rights in

'© To be sure, part of the return above incremental costs may represent

recovery of joint and common costs not attributable to a particular service

or element; and the FCC purports to permit states to make some provision

for those costs. See J.A. 375-76, 377-78, 381-82, 390-91 (Order #f 672,

676, 682, 696). However, the recovery of such costs does not meet the

need for some above-cost return to recoup an investment in new technol-

ogy. Indeed, the FCC has asserted that joint and common costs in the

case of unbundled elements (as distinguished from services) will be quite

small. See id. at 378-79, 389-90 (Order FJ 678, 695).

Moreover, the Order falls far short of ensuring that incumbents can

recover joint and common costs. For example, it expressly forbids states

to use so-called Ramsey pricing to allocate joint and common costs, un-

der which costs are allocated in inverse proportion to demand elasticity so

as to maximize the chance for recovery. See id. at 352-53, 390-91 (Order

Ti 645, 696). Economists generally accept the efficiency of Ramsey pric-

ing, see lowa Utils. Bd., 525 U.S. at 426-27 (Breyer, J., concurring in part

and dissenting in part); yet the FCC rejected it out of hand, J.A. 390-91

(Order J 696). Indeed, even the Interstate Commerce Commission Coal

Rate Guidelines, which the FCC holds up as a model, relied on the prin-

ciple of Ramsey pricing. Coal Rate Guidelines, Nationwide, | 1.C.C.2d

520, 526-27 (1985), aff'd sub nom., Consolidated Rail Corp. v. United

States, 812 F.2d 1444 (3d Cir. 1987). Here, by contrast, the FCC actually

approved the use of “reverse Ramsey pricing” for recovery of joint and

common costs, which is both inefficient and almost certain not to permit

full recovery. See J.A. 390-91 (Order { 696); J. Gregory Sidak & Daniel

F. Spulber, The Tragedy of the Telecommons: Government Pricing of

Unbundled Network Elements under the Telecommunications Act of

1996, 97 Colum. L. Rev. 1081, 1109-10 (1997).

35

an innovation for a period of time are a necessary inducement

for innovation, the market rewards innovation by giving an

innovator the opportunity to price above its costs to make a

return on the innovation:

If prices did not adjust gradually, there would be no

incentive to engage in research and development or

to invest in costly manufacturing to introduce any

generation of products bearing new technology. . . .

[Bjecause of lags, companies earn a return on the

current technology in the interim period before the

new technology becomes available, after the new

technology is introduced, the development cycle

continues. To imagine that prices fall immediately

as a new technology is spotted over the horizon

would be to eliminate any incentives for R&D and

investment in production.

Sidak & Spulber, 72 N.Y.U. LJ. at 1142; see also Economic

Evaluation at 348.

In short, at least in a market such as telecommunications

that is characterized by successive cost-reducing innovations,

incremental costs drop iteratively, and prices lag behind. As

a result, the FCC’s supposition that prices always and instan-

taneously equal incremental costs in a competitive market is

simply wrong. See Joseph A. Schumpeter, Capitalism, So-

cialism and Democracy 105 (3d ed. 1950) (“The introduction

of new methods of production and new commodities is

\ hardly conceivable with perfect — and perfectly prompt —

competition from the start. And this means that the bulk of

what we call economic progress is incompatible with it. As a

matter of fact, perfect competition is and always has been

temporarily suspended whenever anything new is being in-

troduced . . . even in otherwise perfectly competitive condi-

tions.”’).

At least one petitioner suggests that the FCC’s model

does not in practice assume that prices will instantly reflect

36

cost-saving technologies because interconnection contracts

typically have three-year terms and so lock in prices for that.

period. See WorldCom Pet. Br. at 39. But this hardly cor-

rects for the FCC’s error. First, as noted, the FCC’s method-

ology erroneously assumes that ILECs have incorporated the

most efficient available technologies ubiquitously at the time

the TELRIC methodology is employed. Second, an incum-

bent contracts with multiple CLECs at different times, and,

under the FCC’s methodology, the incumbent's network

must be (figuratively) rebuilt every time. When this is cou-

pled with the FCC’s “pick and choose” rule, under which a

CLEC can always opt into the favorable terms of another

CLEC’s subsequent interconnection agreement, see 47

C.F.R. § 51.809, the result is that technologies and prices are

not locked in for the three-year term. Finally, even if TEL-

RIC were applied only once every three years, it would still

belie competitive reality, since no ILEC builds from a

greenfield every three years.

The lack of connection between TELRIC and the opera-

tion of an actual market is further confirmed by the FCC’s

inability to point to any other instance in which a regulator

has used the FCC’s TELRIC methodology in similar circum-

stances — that is, to set prices in an environment marked by

technological change in which the regulatory goal is not to

simulate competition, but to stimulate competition by giving

proper signals for investment. Petitioners note that incre-

mental cost methodologies have been used by courts to set a

price floor below which a price is deemed to be predatory for

antitrust purposes. See AT&T Pet. Br. at 8, 29-30 (citing

MCI Communications Corp. v. AT&T, 708 F.2d 1081, 1115-

17, 1124-25 (7th Cir. 1983)); see also FCC Pet. Br. at 22.

That makes perfect sense: a vendor would have little reason

— other than predation — to price below its long run incre-

mental costs, at least in a market (such as telecommunica-

tions) where incremental costs are generally decreasing. But

to say that some measure of incremental cost represents a

floor beneath which a party should not price does not justify

37

the use of incremental costs as a regulatory price ceiling.'’

Indeed, implicit in making LRIC a price floor is the recogni-

tion that in most situations competitors actually price above

LRIC. As these cases recognize, when a party prices above

LRIC, that creates an opportunity for a more efficient com-

petitor to enter and undercut the incumbent. See, e.g., MCI

Corp., 708 F.2d at 1120. By mandating that UNE prices al-

ways be equal to TELRIC, the FCC creates a disincentive for

such entry.

Petitioners also rely on a single instance in which the

Interstate Commerce Commission used a LRIC-type meth-

odology to set rates that could be charged to captive shippers

for carrying coal by rail. See FCC Brief at 24 & n.9 (citing

Ex Parte No. 347 (Sub-No. 1) Coal Rate Guidelines, Nation-

wide, | 1.C.C.2d 520, 542-46 (1985), aff'd sub nom. Consoli-

dated Rail Corp. v. United States, 812 F.2d 1444, 1451, 1457

(3d Cir. 1987)). That situation was critically different. In

that proceeding, the shippers were captive and the regulatory

goal was not to increase competition so that the shipper

would have multiple choices. With competition unavailable,

the second best solution was for the regulator to attempt to

predict the price that the end user shipper would have to pay

if the market were competitive. Here, by contrast, Con-

gress’s goal was to send appropriate market signals to en-

courage investment and entry by other carriers, so that no end

user will be a captive and market forces will determine

prices. Setting a price based on the hypothesized outcome in

a perfectly competitive market with an ideally efficient car-

'7 Petitioners’ reliance on predatory pricing cases is misleading in an-

other respect: far from reflecting a consensus in support of a methodol-

ogy similar to the FCC’s, predatory pricing cases and literature are rife

with conflicting views on the appropriate measure of costs for establish-

ing a price floor. See, e.g., Barry Wright Corp. v. ITT Grinnell Corp.,

724 F.2d 227, 231-32 (ist Cir. 1983); Phillip Areeda & Donald F. Turner,

Predatory Pricing and Related Practices Under Section 2 of the Sherman

Act, 88 Harv. L. Rev. 697 (1975).

38

rier is fundamentally contrary to that statutory purpose. In-

stead — as Congress prescribed — prices should be based on

the incumbent’s actual costs, so that others will enter the

market and invest in facilities to the extent they can do so

more efficiently. '*

IV. THE ACT PERMITS THE FCC TO IMPLEMENT

OTHER FORWARD-LOOKING METHODOLO-

GIES MORE CONSISTENT WITH THE STATU-

TORY PURPOSES.

The FCC and its supporters are simply wrong when they

portray the agency as having a very limited number of ex-

treme choices in setting UNE prices. In point of fact, the

agency could have chosen a variety of pricing methodologies

that were consistent with the Act. As Verizon argues, pricing

on the basis of historical costs would satisfy the terms of the

7 LRIC-type methodologies have sometimes been used in the electric-

ity industry. See, e.g., Norwood v. FERC, 962 F.2d 20, 21 (D.C. Cir.

1992); Central Lincoln Peoples’ Util. Dist. v. Johnson, 735 F.2d 1101,

1116 (9th Cir. 1984); J. Robert Malko & Philip R. Swensen, Pricing and

the Electric Utility Industry in Public Utility Regulation: The Economic

and Social Control of Industry at 35-77 (1989). There, however, long run

incremental costs generally are increasing. See, e.g., Norwood, 962 F.2d

at 22; Central Lincoln, 735 F.2d at 1121-22. Thus, basing prices on a

long run incremental cost methodology actually yields greater compensa-

tion to incumbents so that they can continue to invest and operate over

the long run. The FCC and its allies suggest that it is unknown whether

an ILEC’s long run incremental costs will be higher or lower than its his-

toric costs (that is, whether long run incremental costs are increasing or

decreasing). See, e.g., J.A. 398-99 (Order | 705); Sprint Pet. Br. at 17.

That is disingenuous at best. The FCC itself acknowledged in its order

that historical costs are generally higher, as did commenters such as MCI;

and petitioners’ briefs are replete with assertions about the rapid pace of

technological change in this industry. See J.A. 399-400 (Order 4 706);

MCI Comments at 63, CC Dkt. No. 96-98 (May 16, 1996); AT&T Pet.

Br. at 4, FCC Pet. Br. at 20. The lineup of the parties in this case leaves

no doubt on this issue: CLECs would not be arguing for LRIC (and

incumbents for historic costs) if they really thought historic costs were

lower than LRIC.

me

39

statute. See Verizon Pet. Br. at 19-23. Moreover, contrary to

the FCC’s assertion that any attempt to measure an incum-

bent’s own forward-looking costs amounts to an embedded

cost methodology, see J.A. 383 (Order { 684), the Act gives

the agency discretion to consider other, more forward-

looking techniques that avoid the infirmities of TELRIC.

As an initial matter, petitioners are wrong when they

suggest that forward-looking costs must be either “long

term,” reflecting the time horizon at which all costs are vari-

able, or “short term,” taking all existing plant as fixed and

including only variable costs, but nothing in between. J.A.

382-83 (Order F¥ 683-84); AT&T Pet. Br. at 17, 37-40;

WorldCom Pet. Br. at 17. “Long term” and “short term” in

this context are nothing more than the two ends of a contin-

uum. See Alfred E. Kahn, The Economics of Regulation:

Principles and Institutions 83-86 (1988). As economists rec-

ognize, “[i]n between these extreme cases, the very short and

the very long run, there are all sorts of intermediate time pe-

riods in which the firm can make partial adjustments” so that

some, but not all, costs that are fixed in the extreme short run

become variable. William J. Baumol, Economic Theory and

Operations Analysis 290 (4th ed. 1977); see also Public Util-

ity Rates at 146-47, 423-24 (“[T]here is no point in assuming

a greater degree of foresight than intelligent people can hope

to enjoy at the time” of setting prices.).

The FCC could have calculated forward-looking costs

over such an intermediate horizon (such as the three-or-four-

year term of a typical arbitration agreement) and then in-

cluded appropriate levels of fixed costs for any existing fa-

cilities that would remain in place during that time period and

would be used to provide the element in question. See, e.g.,

Public Utility Rates at 423 (forward-looking incremental

costs should be measured over “the next several years, from

increases in rates of output to be accomplished by whatever

plant additions and improvements will be warranted in view

of the actual layout and actual capacity of the present plant’).

a

40

In this manner, the UNE price would reflect the efficiency

improvements and new technologies that the ILEC could ex-

pect to have in place and benefit from during the relevant fu-

ture period; at the same time, the price would reflect the ac-

tual operational and depreciation expenses of the other facili-

ties that would be used to provide the element. This would

ensure that CLECs do not operate at a competitive disadvan-

tage vis-a-vis the ILEC and would send appropriate eco-

nomic signals: if a CLEC could provide the element more

efficiently than the ILEC (taking into account the expected

efficiency gains the ILEC would achieve during the term of

the agreement on a forward-looking basis), the CLEC would

have the proper incentive to invest in its own facilities.

The FCC also could have avoided at least some of the

distorting effect of its methodology if it had truly relied on a

Total Element LRIC approach, rather than what amounts to a

Total Network LRIC methodology. In other words, when

pricing an element, the relevant increment could be the total

supply of the element in question, with the remainder of the

network held constant, in the same way that the FCC held

wire center locations, but nothing else, constant. This would,

for example, recognize the reality that any existing service

provider looking to invest in a new facility must take account

of constraints imposed by its other facilities.'”

The FCC could have chosen the efficient component

pricing rule (“ECPR”) methodology advocated by numerous

economists. See, e.g., Sidak & Spulber, 97 Colum. L. Rev. at

1093-99; Baumol, Ordover, & Willig, 14 Yale J. Reg. at 149-

54. This forward-looking methodology is competitively neu-

” Consider, for example, a person considering the purchase of a word

processing program. Suppose Word 8.0 is the most cost-efficient pro-

gram in an abstract sense but requires Windows 2000 to operate. while

Word 6.0 is less efficient but works with Windows 95. If the person has

a computer with Windows 95 and will not replace it within the relevant

time frame, Se Sarwand testing cont fer wand preceeding Ceuis Se Ge

cost of Word 6.0.

41

tral and recognizes the economic reality that, in a real-world

competitive market, the price for which a facility would be

leased is based not only on its incremental costs but also on

foregone opportunity costs. As Justice Breyer noted, “(t]he

FCC rejected that system, but in doing so it did not claim,

nor did its reasoning support the claim, that the use of such a

system would be arbitrary or unreasonable.” Jowa Utils. Bd.,

525 U.S. at 426 (concurring in part and dissenting in part);

see also Sidak & Spulber, 97 Colum. L. Rev. at 1094-97 (ex-

plaining errors in FCC’s discussion of ECPR).

The FCC also could have used a price cap model, as it

and other agencies have done in other contexts. UNE prices

would be based initially on historical costs or current prices

but then reduced over time by an appropriate factor reflecting

general improvements in productivity. See Letting Go at 95-

96. Such an approach would give incumbents the incentive

to innovate and invest, while at the same time giving CLECs

reason to invest in their own facilities whenever they could

provide the same element more efficiently than the incum-

bent (taking into account the reduction in price resulting from

the productivity factor).

Neither the Act nor the court of appeals’ decision re-

quires the FCC to adopt any particular one of these or other

possible approaches. Consideration of the alternatives is for

the agency in the first instance. However, the FCC and its

supporters are simply wrong in suggesting that the agency is

faced with a limited choice between extreme approaches.

The FCC remains free to consider methodologies that avoid

frustrating the statutory purposes. But the FCC’s choice of

TELRIC is contrary to the Act and accordingly is unlawful.

42

CONCLUSION

This Court should affirm that part of the court of ap-

peals’ decision vacating the FCC’s rule 51.505(b), which re-

quired UNE prices to be based on the costs of a hypothetical

network “us[ing] the most efficient technology current!y

available and the lowest cost network configuration.”

Respectfully submitted,

R. STEVEN DAVIS WILLIAM T. LAKE

LAWRENCE D. Huss Counsel of Record

SHARON J. DEVINE JOHN H. HARWOOD II

ROBERT B. MCKENNA SAMIR C. JAIN

QWEST COMMUNICATIONS RUSSELL P. HANSER

INTERNATIONAL, INC. Scott A. SHEPARD

1801 California Street WILMER, CUTLER & PICKERING

Denver, Colorado 80202 2445 M Street, N.W.

(303) 672-2861 Washington, D.C. 20037-1420

(202) 663-6000

Counsel for Respondent

Qwest Communications International, Inc.

June 8, 2001