Confronting Tough Questions About Carriers of Last Resort NARUC February 2008

1. Confronting Tough Questions About Carriers of Last ResortNARUC February 2008 Bob Rowe Senior Partner Balhoff, Rowe & Williams, LLC

2. Overview What is COLR? Examples of state policies Comparison to energy restructuring Traditional (relatively closed) model Disruptive (increasingly open) model – making life and regulation interesting COLR issues in current High Cost Fund Framework for policy reform The COLR challenge About BR&W

3. What is COLR?

4. What is COLR? Broadly – requirement to serve all within a set geographic area. • May be express or implicit from other requirements • Contrast with common carriage (non-discrimination) Working financial definition • Network investment • In specific regions that are costly to serve • That cannot support carrier services • In exchange for support received

5. Examples of State Policies

6. Typical state policies May be express reference to “COLR” or may be stated as specific requirements without mentioning “COLR” Permission to begin service Permission to discontinue service Requirement to stand ready to serve Service quality requirements Offer specific services Rate setting Implicit supports • “Value based pricing” • Vertical > basic • Urban > rural • LD > local • Bus > res

7. State Regulations OverviewFrom 30,000 feet

8. State Initiatives New York Competition III and follow-on Florida • Universal service “an evolving level of access . . . just, reasonable and affordable rates . . . including to rural, economically disadvantaged and high cost areas.” • Recognizes potential for erosion of revenue streams that contribute to universal service • Process for automatic and “good cause shown” waiver of COLR • Generally concerns project developers Texas • Creation and subsequent review of state USF • “Customers in all regions of this state, including low-income customers and customers in rural and high-cost areas, [shall] have access to telecommunications and information . . . that are reasonably comparable to those services provided in urban areas and that are available at prices that are reasonably comparable to prices charged for similar services in urban areas.” PURA § 51.001(g). Wisconsin Investigation into the Level of Regulation “Open a dialogue” concerning “guiding principles,” specific questions and relevant proposals.

9. Comparison to Energy Restructuring Have we seen this movie before?

10. Energy restructuring POLR service generally not an issue in vertically integrated states • Traditionally, a closed system • “Obligation to serve” • Became porous – “uneconomic bypass,” “direct access,” class cost allocation POLR becomes a major (and not adequately anticipated) issue in restructured states • Specific customers or regions • Multiple models, but incumbent generally responsible • Challenge to design new financial and regulatory models • Level of review • How to earn profit/return? • Distribution level decoupling or other ways to address fixed cost recovery • Like telecom – associated with unequal development of competitive models • Different from telecom – focused on commodity, not network, but significant investment and infrastructure issues

11. Traditional (Relatively Closed) Model

12. Traditional (Monopoly) Model of Support Policymakers regulate carriers to ensure policy-based (as opposed to market-driven) ubiquitous/affordable services in exchange for economic viability of entire enterprise Historically, residential and high-cost rural consumers benefited from a system of enterprise-based internal cross-subsidies Support included in access and long distance Geographic rate averaging Value-of-service pricing Residual pricing of value added/”vertical” services Rate differentials unrelated to cost differences System comes under stress as sources (lines of business) of internal cross-support became competitive LD from approximately 1970 Business in the 1990s/2000s Residential with VoIP in 2000s Vertical Urban Long Distance Business Local Residential Basic Rural Consolidated monopoly telecom Lines of business

13. Stages, Policy and Financial Perspectives on universal service goals From Universal Service Funding, Balhoff, Rowe & Williams, LLC (2007)

14. Disruptive (Increasingly Open) Model

15. Competitive disruption and disparity Disparate competition • By customer type • By geography Disparate policy • Obligations • Regulation • Jurisdiction Disparate approaches among states • CETC and ETC practices • Reform of current obligations • Piecemeal or systematic

16. Rural Financial ProblemFrom BR&W Texas Study • Competitive line losses are concentrated in townships, not outside • Companies/BR&W note findings are consistent with data in other states • BR&WR Texas study focused on cost patterns and competitive activity • Methodology involving financial data study based on . . . • “Supported services” only (revenues, costs, investment) • Actual revenues received for provision of these services • Forward-looking costs (12 kft loops – no costs for broadband-capable plant) • Data set • Over 100 Texas wire centers • Approximately 375,000 lines • Approximately $250 million in revenue (including USF receipts) • ~$850 million in gross loop investment (~$450 million net R1/B1 investment) • Analyzed financial characteristics/performance of wire centers in data set • Segmented into ROI groups (negative, 0%-10%, >10%) • Sub-wire center analyses of financial performance • Using geo-coded information, studied the geographic coverage of the cable operators (only in towns) & characteristics of service areas NOTE: “Supported services” revenue streams included in analysis consist of Basic Area Local Revenue, End User Common Line (excluding USF surcharges), Carrier Common Line, Switched Access (including CALLS support), IntraLATA Toll, and High Cost USF where indicated. Costs and investment reflect what is required to provide R1/B1 services (including Loop, Transport & Switching), with returns calculated based on net investment (after accumulated depreciation).

17. Town Center vs. Outside of Town • Fundamental goal – better understand challenges in serving rural customers based on sub-wire center financial & competitive factors • Studied “Town Center” regions, close enough to the CO (less than 12,000 feet) to be served directly, versus “Outside of Town” areas • CO typically placed in population centers • Higher density, lower cost areas • Sub-wire center data are key to understanding . . . • Economics of serving differing geographic regions (in terms of density, costs, investment, etc.) • Why and where wireline competition is occurring, and where it is not • Role of explicit support mechanisms • Future pressures on mechanisms Typical Wire Center Service Area “Town Center” Served directly by Central Office (CO) switch “Outside of Town” Distance from CO too great to be served directly (more sparsely populated and longer loops)

18. Without USF, Rural Service At Risk • Excluding USF receipts, ROI for all wire centers studied would be negative (excluding non-supported services) • Wire centers generating returns below assumed10% cost of capital represent a large percentage of WCs, lines and investment • Uneconomic Outside-of-Town regions are unlikely to attract incremental investment from rational competitors • Quality/availability of service for customers put at risk without sufficient support Source: Sampled Texas companies; Balhoff & Rowe, LLC.

19. Financial Drivers Highlight Risks • ROI driven by high-density & low-capital intensity in Town Centers • Town Center regions vs. Outside of Town areas • 4x the line density • Approx. 50% the per-line investment • Lower maintenance & operating costs • Systemic vulnerability to targeted competitive entry will put policy goals at risk • Competitors target concentrated profits/returns • Economically unattractive outlying areas make ongoing capital allocation problematic • Quality, affordable service less available – consumers lose “Town Center” • $769 avg. invest./line • 4x OoT density • 10% ROI “Outside of Town” • $1,581 avg. invest./line • 2.1x Town Center per line investment • -7% ROI

20. Kingsley Lake Per Line Monthly Cost: $266.94 Reynolds Hill Per Line Monthly Cost: $97.34 Kenansville Per Line Monthly Cost: $143.72 St. Marks Per Line Monthly Cost: $110.97 Statewide Average Per Line Monthly Cost: < $23.00 Everglades Per Line Monthly Cost: $120.80 Embarq Florida example

21. Embarq Florida example Forward looking cost based on Hybrid Cost Proxy Model 1.77M lines in Florida  Average Florida R1 rate is about $15 • Price cap regulated  Embarq receives no high cost loop or local switching support in Florida.  Embarq does receive about $17M a year in CALLS money (access replacement).

22. COLR Issues in Current High Cost Fund

23. 1996 Telecom Act Quality services at just, reasonable, and affordable rates Access to advanced services in all regions Reasonable comparability of rural and urban rates and services Certification of ETCs and CETCs Subsequent growth of fund and shifts in support patterns

24. Total USF is growing Federal Universal Service Fund Elements • Policy/political problem with USF generally identified as persistent “growth” • Growth tied to other questions • Should multiple carriers receive funding? • What is the basis for funding? • Contribution problems—who should contribute and on what basis? • To understand and address the “growth problem” one must correctly identify sources of growth, and craft solutions that address those specific sources • One-time program changes, such as creation of Schools & Libraries (1999) • Shift from intercarrier access payments to explicit support mechanisms (2000-2002) • Emphasis on support for wireless Competitive Eligible Telecommunications Carriers (CETCs) (ongoing)

25. Composition of CETC funding growth • Funds to CETCs exploding • 96% CAGR 2002-2006 • Approximately 61% growth 2005-2006 • Access replacement is approximately 46% of CETC total receipts in 2006 (composed of Interstate Common Line Support, Interstate Access Support &, pre-2005, Long-term Support) • Wireless CETCs did not receive access payments prior to reforms CETC Annual Funding by Fund Element

26. CETC and ILEC Support Annual Growth in Federal CETC Funding v. Rural ILEC Funding Source: USAC Annual Reports and HC05-HC09 appendices. Prepared by Balhoff, Rowe & Williams, LLC CETC federal USF funding continues to expand rapidly • Total CETC funding grew by 97.6% from 2004 to 2005 to $639 million, and then by 53.5% to $980 million by 2006 • Rural CETC funding grew 100.1% from 2004 to 2005 to $316 million, and then by 66.5% in 2006 to $526 million Rural ILEC funding is under pressure, as growth in 2005 was 0.6% and then -3.1% in 2006

27. USF Contraction for Large RLECs 2004-2006 “Growth” In Large Rural Company Federal USF Funding Largest rural carriers are reporting significant contraction in federal USF receipts Among explanations . . . • Increased efficiencies at rural companies • Unanticipated effects of Rural Growth Factor as investment continues but the number of access lines contract Growth and Decline in Funding, December 20, 2007

28. Joint Board 11-20-07 RD POLR the core of current High Cost Fund program Move to separate broadband, mobility and POLR programs within USF POLR recommendations • The Commission should focus on developing a unified POLR mechanism, rather than separate mechanisms dependent on the nature of the carrier. • As part of this, the FCC should address the transfer of exchange or “parent trap” rules. • The current mechanism recognizes loop costs, and to an extent switching costs, but not transport costs, which can be significant. • The mechanism may need to be modernized to account for factors such as targeted competition, competitive line losses, non-regulated revenues, and reduced support under the ILEC cap, despite costs that have remained relatively constant.

29. Joint Board 11-20-07 RD “New entrants often compete only in densely populated areas that have relatively low costs. This makes it much more difficult for incumbent LECs to charge the same rates in both their low-cost densely populated areas and their higher cost, more remote areas. None of the existing support mechanisms adequately recognizes this phenomenon, which generally occurs on a smaller scale than the typical telephone exchange.” Recommended Decision, Para. 22.

30. Implementation Following Joint Board’s recommendation, in context of FCC proceeding, stakeholders should • Further develop facts • Clarify goals • Sharpen (realistic) expectations • In order to • Provide investor clarity • Better match support with costs • Produce customer/community benefits It is very doable for stakeholders from multiple perspectives to come together based on facts, in a structured process, to craft approaches that will allow all of them to invest in services for customers

31. Framework for Policy Reform

32. Competitive Paradigm Shift • Explicit support mechanisms intended to eliminate internal cross-subsidies • Access systems • Federal/state USF programs • Access reforms • Competition targets most profitable business lines, eroding profitability & making cross-subsidies unsustainable • LD market example • Lines of business must be economically justifiable (COLR) • Allow competition to govern competitive markets • Uneconomic regions receive increasingly explicit support • Policy support matches policy duties Urban Long Distance Business Explicit Support (USF) Local Residential Rural (incl. business) Balhoff, Rowe & Williams, USF Funding: Realities of Serving Telecom Customers in High Cost Regions (2007)

33. Reforms must be achievable • Policy goals should be clearly stated • Focus on solutions that are … • Based on accurate analysis & proper issue definition • Adoptable (i.e. politically feasible) • Achievable • Reasonably likely to result in desired goals • Minimize risk of bad outcomes • Sustainable – remain effective as conditions change • Consistent with the point at which reforms are commencing • Policy path dependency – “it’s costly & dangerous to switch from driving on the left side to driving on the right side” • Incorporate feedback mechanisms to adjust & improve based on time & experience See, Barbara Cherry, “The Telecommunications Economy and Regulation as Coevolving Complex Adaptive Systems: Implications for Federalism” (delivered to TRP); Barbara Cherry and Johannes Bauer, “Adaptive Regulation: Contours of a Policy Model for the Internet Economy” (September 2004), presented at the International Telecommunications Society 15th Biennial Conference, Berlin Germany.

34. Framework for achievable reforms Clear Goals Rigorous Problem Analysis Feedback – adjust & improve Candidate Solution Set Achievability Sustainability Continuity Adoptability Adopted Solution Set Implementation

35. HCF goals • Network focus • Support investment to better serve customers • Customer focus • Benefit from service availability & affordability • Comparable services • Limit exposure to harm from high risk “solutions” • Carrier of last resort • Support service uneconomic to provide but required by policy goals • Broadband platform • “No barriers to deployment” of advanced services (Rural Task Force) Clear Goals Rigorous Problem Analysis Feedback – adjust & improve Candidate Solution Set Adoptability Achievability Sustainability Continuity Adopted Solution Set Implementation

36. The COLR Challenge

37. The Challenge Work together to • Understand competitive and financial issues • Address stresses on current model • Sharpen focus on clearly-defined goals • Develop clear, sustainable means to achieve them Consider • NARUC workgroup • Value in surveying current state practices and reform efforts • Ongoing financial analysis • Broad state inquiries (e.g. new Wisconsin docket)

38. Questions to consider What are current express and implicit state policies? What could or should COLR include? What are the costs associated with providing COLR? How should those costs be covered in current and future telecom markets? When and how should COLR be modified or terminated?

39. The Last Word “Competition is a reality today not only in our urban centers, but also increasingly in the small towns, villages and rural communities which are the population cores of rural areas across the country.  It is essential that POLR support be matched as closely as possible to the high cost exurban (“truly rural”) areas. This requires adoption of improved analytical and modeling techniques to examine those costs at a far more granular level than has been heretofore been possible.  Failure to align support with costs as closely as possible could put rural service at risk as surely as the unmanaged ballooning of the high cost program.” Statement of Comm. Landis

40. About BR&W

41. Principals Michael J. Balhoff, CFA, Managing Partner Michael J. Balhoff, CFA, is managing partner at Balhoff, Rowe & Williams. Previously, Mr. Balhoff headed for 16 years the Telecommunications Equity Research Group at Legg Mason, which advised investors about equities in media, cable, wireless, telephony, communications equipment and regulation. Prior to joining Legg Mason in 1989, Mr. Balhoff taught at both the graduate and undergraduate levels. He has a doctorate in Canon Law and four master’s degrees, including an M.B.A., concentration in finance, from the University of Maryland. A Chartered Financial Analyst and a member of the Baltimore Security Analysts Society, Mr. Balhoff has been named on six occasions as a Wall Street Journal All-Star Analyst for his telecommunications recommendations. His coverage of telecom was named by Institutional Investor as the top telecommunications boutique in the country in 2003. He has also testified multiple times before congressional committees, is regularly a featured speaker at conferences for investors and policymakers, and is widely quoted in the media, including television, newspapers as well as communications and business journals. Robert C. Rowe, Esq., Senior Partner Robert C. Rowe, Esq., is a senior partner at Balhoff, Rowe & Williams. Previously, Mr. Rowe served as the Chairman of the Montana Public Service Commission which was responsible for regulating telecommunications, electricity, natural gas, water, and some transportation services. Mr. Rowe also served as President of the National Association of Regulatory Utility Commissioners, Chairman of the NARUC Telecommunications Committee, member and state chair of the Federal-State Joint Board on Universal Service, member of the Federal-State Joint Conference on Advanced Services, chairman of the thirteen state Operations Support Systems Collaborative working with Qwest and its competitors to achieve compliance with Section 271 of the 1996 Federal Telecommunications Act, and member of various advisory boards for university-affiliated programs. Bradley P. Williams, Esq.,Partner Bradley P. Williams joined the firm in 2005 and became a partner at Balhoff, Rowe & Williams in October, 2007. Previously, Mr. Williams was a member of the Strategic Planning & Business Development group at Lowe’s Companies Inc., the Fortune 50 home improvement retailer. Prior to joining Lowe’s, Mr. Williams worked with Mr. Balhoff in the award-winning Telecommunications Equity Research Group at Legg Mason, focusing on incumbent and rural local exchange carriers. Prior to joining Legg Mason, Mr. Williams was a co-founder of eSprocket / Beachfire, a venture-backed company that evolved into one of the pioneers in mediation technology solutions for the financial services sector. Previously, he served as a financial executive for Iron Road Railways Incorporated, a Washington, D.C.-based holding company that integrated, through acquisitions, a significant regional freight rail network serving northern New England and eastern Canada. Mr. Williams began his career as an investment banker in First Union’s Capital Markets Group. He has a BA in Economics from the University of North Carolina and a JD from the University of North Carolina School of Law.

42. Financial advisory FairPoint and several other confidential discussions MTA strategic acquisition Facilitation and coordination of acquisition of NW Investment analysis of wireless and wireline telecom Clients and Services Representative assignments Advocacy/representation Congress (Phantom Traffic / USF for rural carriers Senate Finance Committee concerning USF) FCC (issues regarding access, USF, Phantom Traffic) State commissions (acquisitions, rural exemptions, predatory pricing, financial strength, USF, etc.) Consulting and analysis Strategic facilitation for CEOs/COOs of five carriers Study of divestitures of rural properties USF analysis for RBOCs; study of USF and access for rural telecom carriers Study of municipal broadband