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Dealing with Asymmetric Risk

Improving performance through graduated conditional ROE incentives.

Fortnightly Magazine - May 2009

had been relied on for the productivity offsets employed in AT&T’s price-cap plan. Subsequent FCC staff studies using the price-dual approach by Spavins, Belinfante-Uretsky, and Belinfante were used in modifying the LEC price cap plan in 1995. However, significant inconsistencies existed among these studies regarding the historical and recent productivity performance of the LECs.

Unfortunately, critical analytical errors were embedded in the FCC’s underlying PF analysis. These errors resulted in the FCC significantly underestimating the current, historical, and potential gains in productivity. 10 However, as part of its second-generation framework, the FCC did employ an intriguing construct to infer potential productivity gains on the part of the LECs.

The FCC’s initial review of the three-year old LEC PBR took four years. LECs submitted evidence during the review that their X factors actually had fallen, dropping to only 1.7 percent. The FCC also submitted its updated price dual studies. In its interim decision, the FCC proposed that each firm select its PF from a menu. The higher the PF selected by an LEC, the higher would be its allowed ROE. 11 Presumably, this effort attempted to draw out potential productivity gains through revealed preferences. The FCC offered new interim X options ranging from 4.0 to 5.3. Importantly, the latter option allowed the telcos to retain all of their earnings.

As the FCC noted in a subsequent access tariff order: 12

In the LEC Price Cap Review Order, the Commission amended its rules to establish a minimum X-Factor of 4.0 percent, with two optional X-Factors of 4.7 and 5.3 percent. LECs selecting the 4.0 and 4.7 percent X-Factors are subject to sharing requirements. The sharing mechanism requires a LEC to return to customers its earnings in excess of certain levels, including interest, through a temporary reduction in the LEC’s PCIs in the next annual access period. The amount of the revenue reduction is determined by a temporary adjustment to the LEC’s PCI, which is calculated in the same manner as other exogenous changes to the price cap formula. When applied to the revised X-Factors, the sharing mechanism effectively permits a LEC selecting the 4.0 percent X-Factor to reach a maximum 12.75 percent rate of return. Likewise, a LEC selecting and outperforming an X-Factor of 4.7 percent can realize at most a 14.25 percent rate of return.

The Commission determined that LECs selecting the 5.3 percent X-Factor under the interim plan should not be subject to a sharing requirement. It reasoned that, although the 5.3 percent X-Factor represents a “major challenge” to most LECs, the most efficient ones will opt to use the higher factor if they are permitted to retain all the profits earned, rather than be subject to a sharing requirement. The Commission determined that this revision to its price cap plan will encourage continued movement away from rate-of-return regulation.

Despite having just argued for a 1.7-percent X factor, the majority of LECs selected the new, no-sharing X option of 5.3 rather than the lower, earnings-constrained X options starting at 4.3 (see Figure 1) .

In its follow-on 1997 price-cap decision, the FCC

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