How Telephone Companies Make How Telephone Companies Make MoneyMoney

Doug KitchDoug Kitch

Vince Vince WiemerWiemer

DiscussionDiscussion

Rate-of-Return Regulation

Revenue Requirement

Jurisdictional Separations

Cost Recovery Local Rates Access The NECA Pools Universal Service Funds

Rate-of-ReturnRate-of-Return

A method of utility regulation that provides a company with an exclusive service area but limits their earnings

The utility earns a pre-determined rate-of-return on their utility investment plus recovers allowed operating expenses and income taxes

Rate-of-Return (cont’d)Rate-of-Return (cont’d)

RoR regulation was put in place to encourage the large investments required for utilities Common for gas, electric, and

telephone utilities

The amount of money that a RoR utility is entitled to earn is called their REVENUE REQUIREMENT

Revenue RequirementRevenue Requirement

The authorized level of earnings allowed

Telephone Property, Plant & Equipment- Accumulated Depreciation = Rate Basex Rate-of-Return %= Return on Rate Base+ Operating Expenses+ Income Taxes= REVENUE REQUIREMENT

Revenue Requirement (cont’d)Revenue Requirement (cont’d)

Rate-of-Return regulation means that more plant investment and more operating expenses result in more income (revenue requirement)

Company A Company B

Telephone Plant 10,000,000$ 20,000,000$ Accumulated Depreciation - -

Rate Base 10,000,000$ 20,000,000$ Rate-of-Return 11.25% 11.25%

Return on Rate Base 1,125,000$ 2,250,000$ Operating Expenses 3,000,000 5,000,000 Income Taxes 350,000 600,000

Revenue Requirement 4,475,000$ 7,850,000$

Revenue Requirement ExampleRevenue Requirement Example

Year 1

Telephone Plant 10,000,000$ Accumulated Depreciation -

Rate Base 10,000,000$ Rate-of-Return 11.25%

Return on Rate Base 1,125,000$ Operating Expenses 3,000,000 Income Taxes 350,000

Revenue Requirement 4,475,000$

Year 2

10,000,000$ (1,000,000)

9,000,000$ 11.25%

1,012,500$ 3,000,000

350,000

4,362,500$

Year 3

10,000,000$ (2,000,000)

8,000,000$ 11.25%

900,000$ 3,000,000

350,000

4,250,000$

RoR also means that over time, earnings will decrease as plant depreciates

Jurisdictional SeparationsJurisdictional Separations

Telephone carriers are regulated by both state & federal government State jurisdiction → local & state toll Federal jurisdiction → interstate toll

So rate base and revenue requirement must be divided into their respective jurisdictions

Separations or “cost” studies are performed to accomplish this task

SeparationsSeparations

Net Telephone Plant x Rate of Return

+ Operating Expenses

= Total Revenue Requirement

State & Local

Revenue Requireme

nt

Jurisdictional Separations

Interstate Revenue Requirem

ent

Part 36: Separations RulesPart 36: Separations Rules

Primary purpose of Part 36 is to assign “property costs, revenues, expenses, taxes and reserves between state and interstate jurisdictions”

Costs are categorized based on function and use of the related plant

Basic StudiesBasic Studies

Four basic studies are performed to determine the use of facilities: Traffic Study Commercial Office Study Central Office Equipment Study Cable & Wire Facility Study

Then costs (plant balances & expenses) are allocated to jurisdictions based on these usage factors

Cost RecoveryCost Recovery

Once the jurisdictional revenue requirements are determined, there is the issue of recovering the costs

Telephone companies have three revenue streams: Local service rates from end-users Access rates from long distance carriers

• Interstate and State access rates

Universal Service Funds from the Federal & state governments

Revenue SourcesRevenue Sources

State & Local

Revenue Requireme

nt

Jurisdictional Separations

Interstate Revenue Requirem

ent

Interstate

Access

NECA Pools

Intrastate

Access

USFLocal

Revenue

Total Revenue Requirement

Universal Service & RatesUniversal Service & Rates

All rates are influenced by universal service

Universal Service is a policy that states that all Americans have the right to quality telecommunications services at affordable rates

Because of universal service, local telephone service in urban areas subsidizes rural service

Cost Recovery (cont’d)Cost Recovery (cont’d)

Local Rates are set by State PUCAccess rates are determined by the

cost of providing toll services (access costs) Determined by cost study

Universal service funds make up most of the difference between the cost of providing local service and the local rate

Access RatesAccess Rates

Access costs vary for each telco Access cost ÷ Toll minutes

= Access rate

For ease of administration, the National Exchange Carrier Association (NECA) produces one tariff for a large number of telcos

Access: NECA PoolsAccess: NECA Pools

The telco charges the long distance company the tariff rate (the average access rate developed by NECA)

NECA pools the money and distributes it to the telco based on the telco’s individual costs Determined from the cost study

Universal Service FundsUniversal Service Funds

Universal service funds are government subsidies for local service in high cost area

The telco’s average cost per loop is calculated

[rate base + operating expenses] ÷ number of lines

and compared to the National Avg Cost per Loop (NACPL)

A percentage of the difference is received as a subsidy

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