Rate of Return Regulation in an Engineering World

1. TRIBAL ENGINEERING AND BROADBAND SUMMITRate of Return Regulation in an Engineering World Doug Kitch, CPA, Principal Alexicon Telecommunications Consulting 3210 E. Woodmen Rd, Suite 210 Colorado Springs, CO 80920

2. AGENDA • Brief History of Rate of Return Regulation • Federal Universal Service Funding • National Exchange Carrier Association • So….How Does Engineering Fit Into This? • Challenges in Tribal Areas

3. Rate of Return (RoR) Regulation • Rate of Return Regulation is defined by the FCC as follows: • Local phone companies subject to rate of return regulation are allowed to set rates up to an amount that recovers costs on a dollar-for-dollar basis, plus a reasonable rate of return on the amount invested • A rate of return is the specified percentage return a carrier is permitted to recover on its invested capital

4. Rate of Return Regulation • ILEC’s are permitted a “rate of return” on net regulated plant invested in their telecom network/infrastructure • Regulated telephone plant is also known as “Rate Base” (i.e. rates are developed off of this plant and associated expenses). Types of plant that go into rate base are Central Office Equipment (Switching & Circuit); Cable & Wire Plant (Fiber; Copper); Buildings; Vehicles; Computers; Furniture; etc. • Example: if an ILEC has $500,000 of gross COE Switching investment and $200,000 of accumulated depreciation on that plant, then Net Rate Base = $300,000 • This $300,000 applies a rate of return of 10% to arrive at the rate of return component in determining Revenue Requirement, or $30,000

5. Rate of Return Regulation • Cost-based settlements (also called the “Revenue Requirement”) is calculated as follows: Net Regulated Rate Base x 10% Rate of Return = Return on Rate Base + Regulated Operating Expenses = Revenue Requirement • Greater investment in plant and [certain] expenses result in increased revenues, up to a point • This is clearly counter-intuitive to traditional “supply & demand” business logic

6. Rate of Return Regulation • Traditional Rate of Return regulation means that more plant investment and more operating expenses result in more revenues (revenue requirement)

7. Rate of Return Regulation • Rate of Return also means that over time, earnings will decrease as plant depreciates

8. Rate of Return Regulation • The previous slides show that revenues for telecom profitability and viability are contingent upon “cost recovery”, and therefore how much cost a company incurs will help determine how much revenue they book, and ultimately how financially sound these companies are • This does not mean these RoR-regulated companies have a “blank check” from which to spend as much as they desire • The FCC instituted rules over the past few years to control the amount companies could spend and still get funding, providing for fiscal responsibility and in consideration for controlling the amount of surcharges that end users pay into the USF fund • It should be noted that in the end, every telecom service provider, even not-for-profit companies, should consider a business model like RoR regulation to ensure revenues or funding generated are sufficient to cover the cost of networks, infrastructure, and operations

9. Just Another Fish Story….

10. Universal Service Fund • A few notes about USF: • Universal Service is a federal policy stating that all Americans have the right to quality telecommunications services at affordable rates • All rates are influenced by USF because USF produces very substantial funding • Because of universal service, local telephone service in urban areas help to subsidize service in rural areas • Congressional mandate • Urban areas, because of their density, are less costly to serve • For voice service, USF makes up much of the difference between the cost of providing local service and the local rate • For broadband service, USF makes up a significant portion of the cost to provide data only broadband service compared against national affordability benchmarks

11. Recent USF Reforms • Prior to 2018 • The overall federal budget for universal service [that we are referring to in this context] was $2B, codified in 2011 and in place until recently • RoR regulated companies were constrained to a “budget control mechanism” (BCM) • Broadband deployment was suppressed due to insufficient funding necessary to build out to high cost and rural areas, with the BCM ultimately realized to be causing unintended consequences • FCC December 2018 Order • Make RoR companies whole for 7/1/18 – 12/31/18 • Remove capping mechanism from USF funding from January through June 2019, then entire USF fund rebased and capped based on “2018 unconstrained receipts” plus 7% for additional data only broadband funding • Updating speed requirements from 10/1 to 25/3 Mbps • Re-base and grow the overall fund by the cost of inflation • Increase funding levels for the following types of carriers: • Legacy • ACAM

12. National Exchange Carrier Association (NECA) • Provides a “pooling” mechanism for almost all companies in the rate of return industry for interstate traffic/services • Through NECA’s national tariff: all costs from all pool members / all demand from all pool members = pricing/rates that are developed for various types of traffic (Ethernet, Switched Access, Voice, T1’s, DSL, non-DSL Special Access, IP, etc) • Here is how the process works: • NTTA ILECs, as a member of NECA, are required to charge rates developed by NECA • NTTA ILECs then collects those charges from end users and interexchange carriers and turns that money over to NECA • In return, NTTA ILECs get payment from NECA for reimbursing its costs • NECA also collects monies from the Universal Service Administrative Company (USAC) for any USF monies involved in the above clearinghouse process, and also submits those monies to NTTA ILECs

13. Competitive Services • Overbuild of neighboring areas (i.e., “edge out”) • Provide competing ISP services • Utilize fixed wireless technologies • Support opportunities are limited • Federal Universal Service Support is generally not an option at this point • RUS programs may offer some help • Telecommunications Loans (with SUTA provisions) • Community Connect program • ReConnect Program • Availability depends in part on broadband availability in the target area • State programs

14. Engineering Aspects Policies to Ponder • Engineering for the Future • Technology Transitions (i.e., TDM to IP) • New sources of revenues • 5G will require fiber • Public Interest • The most efficient technologies to advance universal service • Bringing current technologies to high cost areas • Affordability • The best way to provide service • Continuing innovation • Accountability • Broadband mapping • Performance Testing

15. Engineering Aspects Let’s look at the following: • Useful lives of technology • Fiber • 20+ years • Electronics • 6 to 10 years Let’s take the following comparison: • FTTH. Significant deployment costs; long useful life; incomparable transport medium; infinite capacity; ultimate quality • Fixed Wireless. Lessor deployment costs; shorter economic life; robust but finite service capacity (even with 5G); propagation issues; signal limitations; subject to weather Question: is it better to deploy a [more costly] state of the art fiber network now knowing that the cost savings on the back end will take significant pressure off of funding needs down the road? (refer to slide #7)

16. Engineering: Fun Facts Did you know…. • Operating and maintenance costs comprise roughly 80% of the cost of providing telecommunications service • There are still customers residing on Tribal lands that have zero access to any telecommunications service • There are Exabytes(one billion gigabytes) and Zettabytes (one thousand Exabytes!) that will one day exist…probably on Dave Westmacott’s computer alone…. • Lasers are being considered to replace optical fibers one day • There are still DMS10 switches in service today

17. Challenges in Tribal Areas • “Many Tribal communities face significant obstacles to the deployment of broadband infrastructure, including high buildout costs, limited financial resources that deter investment by commercial providers and a shortage of technically trained members who can undertake deployment and adoption planning.” (National Broadband Plan, 2010) • “Tribal governments, and by extension, Tribally-owned and operated carriers, play a vital role in serving the needs and interests of their local communities, often in remote, low-income, and underserved regions of the country. Tribally-owned and operated carriers serve cyclically impoverished communities with a historical lack of critical infrastructure. Reservation-based economies lack fundamental similarities to non-reservation economies and are among the most impoverished economies in the country. Tribal Nations also cannot collateralize trust land assets, and as a result, have more limited abilities to access credit and capital.” (FCC USF/ICC Transformation Order, 2011) • “Tribal areas and communities continue to lag behind other areas and segments of American society with respect to broadband and telecommunications services. High poverty rates and low-income levels in tribal lands—along with the fact that many tribal communities are located in remote rural areas (often with rugged terrain)—are major factors that may explain why tribal areas have comparatively poor levels of broadband access, and why providers may lack an economic incentive to serve those areas.” (Congressional Research Service, 2019) • “An estimated 35 percent of Americans living on tribal lands lack broadband service, which could hinder tribal efforts to promote self-governance, economic opportunity, education, public safety, and cultural preservation. However, little federal funding aimed at increasing broadband service actually goes to tribal entities, even though the National Broadband Plan stressed that tribes needed substantially greater financial support and recommended that federal agencies facilitate tribal access to broadband funding opportunities.” (GAO, 2018)

18. Challenges in Tribal Areas • Closing the digital divide • FCC defines “broadband” as service providing at least 25/3 mbps FCC 2018 Broadband Progress ReportAmericans With Access to 25/3 Speeds (fixed) & 5/1 (mobile) Population in millions

19. Challenges in Tribal Areas 2018 Broadband Progress Report Tribal Areas with Access to 25/3 (fixed) and 5/1 (mobile) Broadband Service

20. Thank You! • Doug Kitch • dkitch@alexicon.net • 719-531-6342