Verizon v. NH PUC CV—04— 65—PB 08/17/05

UNITED STATES DISTRICT COURT FOR THE DISTRICT OF NEW HAMPSHIRE

Verizon New England, Inc.

v. Case No. 04-CV-65-PB Opinion No.

New Hampshire Public Utilities Commission

MEMORANDUM AND ORDER

Verizon New England, Inc.1 ("Verizon") owns and operates a

vast telecommunications network in the state of New Hampshire.

This network consists of various elements such as loops (wires

that connect telephones, fax machines, and modems to switches),

switches (devices that direct communications to destinations),

and transport trunks (wires and cables that connect switches to

other switches). See AT&T Corp. v. Iowa Util. B d.,

(1999) (describing elements of a local telecommunications

network).

1 Verizon New England is a subsidiary of Verizon Communications, Inc. In New Hampshire, Verizon New England does business as Verizon New Hampshire. Verizon is required by the Telecommunications Act of 1996,

Stat. 56 ("Telecommunications Act" or

"Act"), to provide competing telecommunications carriers with

access to the elements of its network on an unbundled basis.

(c)(3). The Act, in turn, authorizes Verizon to

charge a "just and reasonable" rate for access to such elements.

See

(d)(1). One of the components of a just and

reasonable rate is an allocation for "cost of capital." See

(b)(2). The Act's implementing regulations

specify that cost of capital must be "forward-looking," i d ., but

otherwise leave the concept undefined.

On January 16, 2004, the New Hampshire Public Utilities

Commission ("PUC") issued an order setting Verizon's cost of

capital for all purposes at 8.2%. See Order Establishing Cost of

Capital ("Cost of Capital Order") at 71. Verizon challenges the

order to the extent that it applies to the rates that Verizon

will be permitted to charge for access to its unbundled network

elements ("UNEs") because it contends that the PUC failed to use

the forward-looking methodology that the Act and its implementing

regulations require. Because I find this argument persuasive, I

- 2 - vacate the PUC order.

I. The Cost of Capital Order

The Cost of Capital Order states that a utilities' weighted

average cost of capital "is determined by multiplying the cost of

equity by the percentage of equity in the company's capital

structure, and adding that number to the cost of debt, similarly

multiplied by the percentage of debt in the capital structure."

Cost of Capital Order at 4. Following this approach, the PUC

proceeded to identify the capital structure, the cost of debt,

and the cost of equity that it would use in determining Verizon's

cost of capital.

The PUC determined that Verizon's capital structure should

be 55% debt (comprised of 53% long-term debt and 2% short-term

debt) and 45% equity. See i d . at 57. It based this

determination on the average of Verizon New England's reported

capital structure at year-end 2000 and 2001, and as of June 30

and September 30, 2002. See i d . at 50-51, 16. The Commission

used book values for Verizon New England because the company did

not maintain separate books for its New Hampshire operations.

- 3 - See i d . at 48-51.

The PUC determined that Verizon's cost of debt was 2% for

short-term debt2 and 7.051% for long-term debt. See i d . at 57.

It explained that the short-term debt rate was undisputed and it

drew the 7.051% long-term debt rate directly from the "embedded

cost of debt for Verizon New England as of the balance sheet for

June 30, 2 0 02." I d . at 57.

The Commission set Verizon's cost of equity at 9.82%. See

i d . at 70. It used a three-stage version of the "Discounted Cash

Flow" ("DCF") method to arrive at this figure. It described the

DCF method by stating that it can be explained as

K = Do(1 + g) + g "where K is the cost of equity. Do PO

is the current annual dividend on one share of common stock, Po

is the current stock price and g is the anticipated growth

rate."3 I d . at 4. The Commission drew its inputs for stock

2 The PUC apparently arrived at the 2000 short-term debt figure by taking reports of Verizon New England's average daily short-term debt balances for the 13-month period ending December 31, 2002 (4.35%) and making a downward adjustment to account for short-term volatility. See i d . at 56.

3 For a more detailed description of the DCF method, see Roger A. Morin, Regulatory Finance: Utilities Cost of Capital (1994) 99-129.

- 4 - price, annual dividend, and growth rate from a composite of two

telecommunications companies that it determined were comparable

to Verizon New England in "risk profiles, [and] positive dividend

earnings growth on average over the last five years. . . Id.

at 31, 61.

The Commission rejected Verizon's proposal to add a 5.48%

risk premium to its cost of capital. See i d . at 47. Thus,

applying Verizon's cost of debt (2% for short-term debt, 7.051%

for long-term debt) and its cost of equity (9.82%) and using the

approved capital structure (55% debt and 45% equity), the

Commission determined that Verizon's weighted average cost of

capital was 8.2%. See i d . at 70.

II. ANALYSIS

Verizon argues that the Cost of Capital Order cannot stand

because the PUC improperly based the order primarily on

historical data rather than the forward-looking cost of capital

that a hypothetical business would incur if it were to offer

access to UNEs in a competitive market. The PUC defends the

order primarily by arguing that it was entitled to use historical

- 5 - data because it supportably found that Verizon's historical cost

of capital is a reliable proxy for its forward-looking cost of

capital. To resolve this dispute, I begin by taking a closer

look at what the Federal Communications Commission ("FCC") likely

meant when it required state commissions to set cost of capital

by using a forward-looking methodology. I then examine the Cost

of Capital Order to determine whether the PUC used the correct

methodology.

A. Forward-Looking Cost of Capital

Neither the Telecommunications Act nor its implementing

regulations explain what it is that qualifies a method for

determining cost of capital as "forward-looking." We know,

however, that the Act provides that state commissions must base

access rates for UNEs on "cost" and that cost must be determined

"without reference to a rate-of-return or other rate-based

proceeding."4

(d)(1)(A)(1). Because cost of

4 For a detailed discussion of rate-of-return regulation see Verizon Communications, Inc. v. F CC,

(2002). For a comparison of rate-of-return regulation with alternative pricing methodologies, see Jonathan E. Nuerchterlein & Philip J. Weiser, Digital Crossroads. American Telecommunications Policy in the Internet Age (2005), Appendix A.

- 6 - capital is a component of an incumbent local exchange carrier's

("ILEC") recoverable cost. See

(b)(2), it is at

least evident that a forward-looking method for determining

capital cost must be something other than rate-of-return

regulation under a different name. Thus, because the forbidden

rate-of-return method of rate setting looks to an ILEC's

historical costs as a starting point, see Verizon.

, it is reasonable to assume that, as the term "forward-

looking" implies, the FCC intended state commissions to identify

an ILEC's anticipated future cost of capital rather than merely

to adopt its historical costs.

It also seems reasonably clear that the FCC intended state

commissions to adopt certain assumptions that are described in

the Act's implementing regulations when setting a cost of

capital. The regulations identify a forward-looking cost of

capital as a component of the "total element long run incremental

cost" ("TERLIC") method of rate setting that the FCC adopted in

place of traditional rate-of-return regulation. See i d . at 496

(identifying forward-looking cost of capital as a component of

TELRIC). TELRIC, in turn, requires state commissions to base

- 7 - access rates for UNEs on the cost of operating a hypothetical

network that is constructed "using the most efficient

telecommunications technology currently available and the lowest

cost network configuration given the existing location of an

incumbent EEC's wire centers."

(b)(1). It

follows, therefore, that when calculating cost of capital under

TELRIC, state commissions must attempt to determine the capital

cost of operating the hypothetical network that TELRIC envisions

rather than the network as it currently exists.

It is also important to bear in mind that the

Telecommunications Act was designed to promote competition in the

local telecommunications marketplace. Verizon,

-

89. TELRIC encourages competition over an ILEC's existing

network by requiring state commissions to set access rates based

on the cost of a hypothetical state-of-the-art network rather

than the presumably higher costs that the ILEC actually incurred

in building its network. The FCC has recognized, however, that

competitors will have no incentive to engage in the type of

facilities-based competition that is the Act's ultimate aim if

the allowed cost of capital is too low. As it has explained: To calculate rates based on an assumption of a forward- looking network that uses the most efficient technology (i.e. the network that would be employed in a competitive market), without also compensating for the risks associated with investment in such a network, would reduce artificially the value of the incumbent LEG network and send improper pricing signals to competitors. Establishing UNE prices based on an unreasonably low cost of capital would discourage competitive LECs from investing in their own facilities and thus slow the development of facilities-based competition.

In the Matter of Review of the Section 251 Unbundling Obligations

of Incumbent Local Exchange Carriers ("Triennial Review Order"),

*17396-97 5 682 (2003). To address this

concern, the FCC required state commissions to adopt certain

assumptions when setting a forward-looking cost of capital. Most

significantly, such commissions must assume that an ILEC is

offering to lease network elements in an environment in which

there is facilities-based competition. I d . at 5 680. This

assumption is vital, the FCC reasoned, because facilities-based

competition increases risk and increased risk in turn results in

an increased cost of capital. I d . at 5 681. Accordingly, a

forward-looking process for determining cost of capital must

attempt to identify the hypothetical cost of capital that a

- 9 - competing local exchange carrier ("LEG") would face in building

and operating a network in an environment in which there is

facilities-based competition. Further, the process must account

for the FCC's determination that a market with facilities-based

competition will produce greater risk and hence a higher cost of

capital than a market without such competition.

To summarize, the forward-looking method for calculating

cost of capital envisioned by the Telecommunications Act and its

implementing regulations requires an assessment of anticipated

future costs rather than historical costs, it requires an

assessment of the cost of capital that a competing LEG would

incur in building and operating the hypothetical network that

TELRIC assumes, and it requires that this assessment be made in

an environment in which there is facilities-based competition.

B. The Cost of Capital Order

A careful review of the Cost of Capital Order leaves no

doubt that the PUC used a historical method rather than a

forward-looking method to determine all three of the essential

components of Verizon's cost of capital. The Commission relied

directly on Verizon New England's historical capital structure in

- 10 - selecting a capital structure for Verizon's New Hampshire

operations. It also explained that it had relied on data from

Verizon New England rather than Verizon New Hampshire only

because Verizon New England did not maintain separate books for

its New Hampshire business. The Commission also based its long­

term debt rate directly on Verizon New England's embedded debt

costs. Finally, although it did not use inputs from Verizon New

England for its cost of equity calculation, the Commission

selected inputs from two other telecommunications companies with

risk profiles similar to Verizon's. Given this approach, it is

difficult to see how the PUC can credibly maintain that it

calculated Verizon's cost of capital "without reference to a

rate-of-return or other rate-based proceeding,"

(d)(1)(A)(i), as the Telecommunications Act requires.

In response, the PUC offers only straw man arguments to

support its claim that it used a forward-looking methodology.

For example, it argued in the Cost of Capital Order that its

methodology was appropriate because TELRIC does not bar a state

commission from using the same cost of capital for both an ILEC's

retail and UNE rates. Cost of Capital Order at 43-44. While

- 11 - this may well be true in theory, it fails to address Verizon's

contention that the PUC's methodology was not forward-looking.

New Hampshire law requires the PUC to use a rate-of-return

methodology to set Verizon's retail rates. See Appeal of Chester

Bridge Corp.,

(1985) (describing rate setting

method required under

). The

Telecommunications Act, in contrast, requires that access rates

for UNEs be set "without reference to a rate-of-return or other

rate-based proceeding."

(d)(1)(A)(i). Thus,

while it is conceivable that these two methods could produce the

same cost of capital in certain cases, this theoretical

possibility does not relieve the PUC of its obligation to set UNE

rates using the methodology required by federal law.

The Commission also makes much of the fact that it used the

DCF method to determine Verizon's cost of equity. Def.'s Mem. at

13-14. The DCF method, however, is neither inherently forward-

looking nor inherently backward-looking. It is the selection of

inputs that makes the difference. If, as was the case here, a

commission selects inputs that seek to replicate the ILEC's

historical stock price, dividend and growth rate, without

- 12 - accounting for the risk that a competing LEG would face in

offering access to UNEs in the kind of market that TELRIC

assumes, its use of the DCF method is historical rather than

forward-looking.

The PUC alternatively argues that it reasonably relied on a

historical method for computing Verizon's cost of capital because

Verizon failed to prove "that it would face greater risks in a

fully competitive wholesale market than it does in the provision

of retail services." Def's Mem. at 9. In light of this failure

of proof, the Commission reasons that Verizon's historical cost

of capital is an acceptable substitute for its forward-looking

cost of capital. I reject this argument because it misstates

Verison's burden of proof and fails to properly account for the

assumptions about risk and its effect on cost of capital that are

an essential part of a forward-looking methodology.

As I have already noted, the FCC has concluded that the

provision of UNEs in a market in which there is facilities-based

competition necessarily involves greater risk than ILEC's

currently face in the highly regulated retail markets in which

they operate. It has also determined that increased risk

- 13 - necessarily results in an increased cost of capital. In the face

of these determinations, the PUC cannot justify its reliance on

Verizon New England's historical cost of capital as a proxy for

its forward-looking capital cost merely by claiming that Verizon

has failed to prove what the Telecommunication Act's implementing

regulations require the PUC to assume. While the

Telecommunications Act does not flatly prohibit embedded cost

methods such as the one that the PUC used in this case, as the

Supreme Court has observed, "it seems safe to say that the

statutory language places a heavy presumption against any method

resembling the traditional embedded cost-of-service model of

rate-setting." Verizon,

. The PUC has failed to

overcome this presumption merely by claiming that Verizon has not

proved that it will face greater competitive risk in the kind of

market that TELRIC assumes.

IV. CONCLUSION

Because each of the variables relied upon by the PUC to

calculate Verizon's overall cost of capital were calculated using

an improper methodology, the Cost of Capital Order must be set

- 14 - aside. Verizon's motion for summary judgment (Doc. No. 36) is

therefore granted, the PUC's motion for summary judgment (Doc.

No. 38) is denied, and the clerk is instructed to enter judgment

accordingly.5

SO ORDERED.

/s/Paul Barbadoro________ Paul Barbadoro United States District Judge

August 17, 2005

cc: Lynn R. Charytan, Esq. Thomas J. Donovan, Esq. Suzanne M. Gorman, Esq. Daniel J. Mullen, Esq.

5 The PUC has made the additional argument that this case must be dismissed because it was not filed in a timely manner. Absent the existence of an explicit limitations period, civil claims that arise under federal statutes enacted after December 1, 1990 are subject to

(a) which imposes a four- year limitations period on such actions. See Peiepscot Indus. Park. Inc. v. Maine Cent. R.R. Co..

, 203 n.5 (1st Cir. 2000). This case was brought under the Telecommunications Act of 1996, a statute enacted after December 1, 1990 without any explicit limitations period. Section 1658(a) therefore applies. This case would thus have had to have been filed on January 16, 2008, four years after the PUC rendered its order, for it to be barred. Instead, Verizon's suit was filed on February 19, 2004, well within the statutory period. The PUC's claim that the statute had run prior to the date on which Verizon filed this action therefore has no merit.

- 15 -