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EXECUTIVE SUMMARY OF THE PRE-FILED EVIDENCE OF JOHN TODD AND GREG MATWICHUK

for ARC et al, BCOAPO et al, CAC/MSOS & The City of Calgary

in re: CRTC PN 2001-37: PRICE CAP REVIEW

1. The purpose of this proceeding is to develop an appropriate design for the second generation of price caps in the Canadian telecommunications industry. In order to get this design “right” it is critical to first establish a clear vision of the regulatory objectives that it is intended to meet.

Public Notice 2001-37 identified objectives for the second generation that include:

• balancing the interests of the three main stakeholder groups (para.16)
• ensuring equitable sharing of benefits between ILECs and ratepayers (para.18)
• ensuring the maintenance of high quality of service (para.35)

In addition, our review of the broader regulatory objectives of the Commission indicate that the price cap regime should provide incentives for:

• Cost minimization;
• Cost effective innovation;
• Optimal adjustment to input cost conditions; and
• Minimization of cross subsidization.

1.It appears that the existing price cap regime has fallen short of its goals. In particular, it has not resulted in rates and profitability levels that are reflective of the expected performance of a competitive industry exhibiting comparable productivity gains. The implication is that the benefits of the price cap regime have not been divided equitably. Residential customers, in particular, have gained little from the regime, in part because effective competition in the local telephone service market in Canada remains an elusive goal relative to other market segments. The rate reductions required under the cap have been enjoyed almost exclusively by the market segments that are more susceptible to market entry.

2.Competition has struggled and gained only a very small foothold in the market for a number of reasons. The ILECs appear to have a significant competitive edge due to their initial dominance of the market. The price cap regime both has enabled the ILECs to achieve very high profit levels, making them powerful competitors and has permitted them significant pricing flexibility which has enabled them to consolidate their dominance by targeting competitors and making entry unprofitable for those who have braved the hostile environment.

3.It is becoming increasingly evident that the price cap regime has not approximated the results of an effectively competitive market. In competitive markets, only exceptional firms earn above-average profits. In this market, ILECs earn high profits and competitors fail. This experience, however, is consistent with the experience in other jurisdictions where initial target productivities have frequently been found to be too conservative and have therefore been increased over time.

4. The proposals of the ILECs will further entrench their dominance by making non-competitive services even more lucrative; thereby, enriching the “war chest” used to challenge new entrants.

5. In order to avoid this result, it will be essential that the second generation regime maintain the conceptual link between prices and underlying costs. The price cap should ensure that capped prices move in line with the expected downward cost trend due to continued strong productivity growth. The cap should not be designed on the basis of the perceived customer tolerance for rate increases, which has nothing to do with underlying costs. The fundamental principle that just and reasonable rates are reflective of costs has not been altered by the introduction of price caps.

6. The recommended price cap regime is intended to be competition-friendly and to produce price-cost relationships that are truly reflective of the outcomes that would be expected under effective competitive market conditions. Namely, normal performance should result in a normal return. Only superior performance should be rewarded with superior returns. The essential elements of such a regime are reflected in our fouir recommendations.

Recommendation 1 (Baskets): There should be separate baskets, with the price cap formula described below applying separately to each basket, for (i) basic residential services in HCSAs, (ii) basic residential services in non-HCSAs and (iii) basic business services.

Recommendation 2 (Formula): The Price Cap for each residential basket (HCSA and non-HCSA) of capped services should be constrained to increase by no more than GDP-PI – X%, similar to the current cap, where X is significantly higher than the current 4.5% figure. The only constraint required on local business services is the constraint on individual tariff items as discussed below.

Recommendation 3 (Basic Residential Constraint): Increases in basic residential services rates should be constrained so that the cumulative rate increase does not exceed the cumulative increase in the GDP-PI in the previous years of the second generation price cap regime. For example, an increase could be implemented in the third year that does not exceed the increase in the GDP-PI during the first two years of the second generation term.

Recommendation 4 (Basic Business Constraint): Increases in local business rates should be constrained so that the cumulative rate increase for each individual tariff item does not exceed 10% in any 12 month period.

EXECUTIVE SUMMARY

OF THE TESTIMONY OF DR. TREVOR ROYCROFT

FOR ARC et al, BCOAPO et al, CAC/MSOS

IN RE CRTC PN 2001-37: PRICE CAP REVIEW

August 20, 2001

• Evidence in the U.S. indicates that price cap regulation is superior to rate-of-return regulation in providing incentives to increase efficiency.
• Statistically significant increases in Total Factor Productivity (TFP) growth have been experienced by regulated companies in the U.S. under incentive regulation. These productivity gains have persisted across multiple terms of price cap plans.
• Sharing of these productivity gains has been a less successful aspect of the application of price cap regulation in the U.S It is likely that shareholders have reaped a disproportionate share of these gains.
• Given the structure of the CRTC’s price cap plan, and evidence provided by Bell Canada and Telus, I believe that Canadian ILECs subject to price cap regulation have experienced similar incentives to improve efficiency and similar increases in Total Factor Productivity growth as those resulting from increased incentives experienced by ILECs in the U.S.
• ILEC proposals in this proceeding to eliminate the productivity component of a price cap plan are not appropriate.
• Accommodative entry policy alone should not be the basis for determining whether retail price regulation should be abandoned. Examination of market structure and empirical evidence is the appropriate approach to utilize when determining the proper degree of regulation of retail prices.
• Where a policy of accommodative entry exists, price cap regulation can improve the market outcome. Price cap regulation can coexist with emerging competition in a market, until analysis of market structure indicates that competitive forces are capable of disciplining retail prices and preventing cross subsidy.

EXECUTIVE SUMMARY

OF THE TESTIMONY OF BARBARA ALEXANDER

FOR ARC et al, BCOAPO et al, CAC/MSOS,, and MKO

IN RE CRTC PN 2001-37: PRICE CAP REVIEW

August 20, 2001

• A quality of service incentive mechanism is needed as part of a price cap or other incentive regulation regime, in order to offset strong countervailing incentives for ILECs to cut costs, and to replace the review of service quality typically undertaken in revenue requirement proceedings.
• Competitive market forces cannot yet be relied upon to ensure adequate levels of service quality.
• Regulators throughout the USA have adopted service quality incentive regimes in response to deteriorating quality of service under alternative regulatory regimes, and, where service quality is adequate, to assure that it continues to be adequate under multi-year rate plans.
• Canadian ILECs also show poor quality of service performance since the onset of price caps
• Bell et al’s proposed “Residential Service Quality Guarantee” provides an inadequate incentive for meeting the CRTC’s service quality standards.
• An effective Quality of Service incentive regime imposes penalties on ILECs for sub-standard service. Rewards for above-standard performance are unnecessary and inappropriate.
• Each service quality indicator in question should stand on its own, such that sub-standard performance in one area cannot be offset by good performance in another area.
• Applicable penalties must be sufficiently large to constitute an effective deterrent to sub-standard performance. In this respect, each ILEC should be subject to a maximum penalty amount equal to 4-5% of its local exchange service revenues.
• Penalty dollars should be divided equally among indicators, and allocated to the first 30% deterioration below the standard for each indicator, such that the maximum penalty for any given indicator is incurred once the company’s performance falls to 70%.
• Individual customer rebates are useful supplements to the company-wide penalty, but are not an effective substitute.
• Service quality results should be reported annually to subscribers via a bill insert.
• Information on complaints and Terms of Service violations should be published annually by the Commission.
• ILECs should publish and distribute to their subscribers a short, plain language document explaining key customer rights and responsibilities.