ARCHIVED -  Telecom Decision CRTC 89-4

Telecom Decision

Ottawa, 22 February 1989

Telecom Decision CRTC 89-4

BELL CANADA - 1988 CONSTRUCTION PROGRAM REVIEW

Table of Contents

I INTRODUCTION

II THE 1988 VIEW AND THE UPDATE FOR 3 1988 AND 1989

A. General

B. Usage Categories

1. Demand Category
2. Programs Category
3. Replacement Category
4. Support Category

C. Changes from the Previous View

D. Switching Equipment Modernization - Exchange Program

1. Background
2. Positions of Interested Parties
3. Position of the Company
4. Tests of Reasonableness and Scope of Review
5. Commission Assessment

E. National Telecom Canada Fibre Optic Transmission System

F. Integrated Services Digital Network

G. ALEX Electronic Information and Translation Service

H. Costs of Provisioning, Utilization Levels and Cost/Demand Ratios

I. Modernization Program for Urban Outside Plant Facilities

J. Provisioning of Data Services

K. Economic Evaluation Studies

L. Plant Account Information

M. Separation and Analysis of Capital Expenditures on a Regional Basis

N. Impact of Craft and Operators Strike on Capital Expenditures

O. Adequacy of Control Indicators for Motor Vehicle Maintenance

P. Construction Program Review Process

Q. Conclusion

I INTRODUCTION

In CRTC Telecom Public Notice 1988-8, 5 February 1988, the Commission announced that it would conduct a review of the construction program (CPR) of Bell Canada (Bell). On 25 March 1988, Bell filed the 1988 View of its construction program for the years 1988 to 1992, inclusive, along with other information that the Commission had requested. On 20 May 1988, Bell filed its update to the 1988 View (the update) for the years 1988 and 1989, together with its written responses to interrogatories. The review meeting was held on 7 and 8 June 1988. It followed a preliminary meeting at which the company gave a presentation and answered questions about its forecasting process.

Participants in the 1988 CPR included the Association of Competitive Telecommunications Suppliers (ACTS), the Consumers' Association of Canada (CAC), Canadian Business Telecommunications Alliance (CBTA), the Government of Ontario (Ontario), the Government of Québec (Québec) and the National Anti-Poverty Organization (NAPO). These parties, with the exception of ACTS, filed comments by 6 July 1988. Bell filed reply comments on 27 July 1988.

II THE 1988 VIEW AND THE UPDATE FOR 1988 AND 1989

A. General

In its 1988 View, Bell estimated that construction expenditures during the five-year period from 1988 to 1992 would total $10,798 million. Of this amount, the company expected to spend $2,168 million in 1988 and $2,150 million in 1989. The update indicated the principal variations from the 1988 View for the years 1988 and 1989. It reflected the impact of Bell Canada - Accounting For Real Estate, Telecom Decision CRTC 88-3, 17 March 1988 (Decision 88-3) and Bell Canada - 1988 Revenue Requirement, Rate Rebalancing and Revenue Settlement Issues, Telecom Decision CRTC 88-4, 17 March 1988 (Decision 88-4), as well as other changes that had occurred since the 1988 View was prepared. In the update, Bell estimated, relative to the 1988 View forecast, increases in expenditures of $52 million for 1988 and $20 million for 1989.

Taking these variations into account, Bell's revised forecast of total annual capital expenditures for the five years from 1988 to 1992 is as follows:

$ Millions

1988 2,220
1989 2,170
1990 2,100
1991 2,140
1992 2,240

Total 10,870

B. Usage Categories

1. Demand Category

The demand category contains all capital expenditures required to meet the requests of new and existing customers for a wide variety of telecommunications services. It includes expenditures for exchange facilities, exchange station apparatus, exchange station connections, large private branch exchanges (PBXs), intertoll facilities, data facilities, data station equipment, and other facilities for the provision of special service offerings. The updated forecast expenditures in this category for the years 1988 and 1989 represent approximately 72% of the total forecast expenditures for this two-year period and are approximately 22% higher than the actual demand expenditures for the years 1986 and 1987.

2. Programs Category

The programs category includes expenditures for various modernization projects, such as the replacement of obsolete facilities with more up-to-date and reliable equipment, the installation of state-of-the-art measuring devices and the provisioning of modern centralized operations and maintenance centres. The company undertakes these projects in order to meet changing customer requirements, to improve both quality of service and operational efficiency, to reduce costs and to protect the long-term viability of the network through the application of new technologies. Major programs include the modernization of exchange and intertoll switching facilities, transmission equipment, and urban outside plant facilities, as well as the implementation of common channel signalling and a computerized customer record information system. The updated forecast expenditures in this category for the years 1988 and 1989 represent approximately 15% of the total forecast expenditures for this two-year period and are approximately 31% higher than the actual programs expenditures for the years 1986 and 1987.

3. Replacement Category

The replacement category includes expenditures for the replacement of plant that is, or will be, out of service because of damage or wear. It also provides for unplanned relocations necessitated by the actions of external agencies such as a highway authority. The updated expenditures in this category for the years 1988 and 1989 represent approximately 4% of the total forecast expenditures for this two-year period and are approximately 19% higher than the actual replacement expenditures for the years 1986 and 1987.

4. Support Category

The support category includes expenditures relating to the provision of administrative support facilities for the operation of the company's business. These facilities comprise administrative land and buildings, furniture and office equipment, general purpose computers, and motor vehicles and other work equipment. The updated expenditures in this category for the years 1988 and 1989 represent approximately 9% of the total forecast expenditures for this two-year period and are approximately 23% higher than the actual support expenditures for the years 1986 and 1987.

C. Changes from the Previous View

Bell's updated 1988 View forecasts an increase in total capital expenditures over the updated January 1987 View of 7.4% ($597,000) for the common four-year period 1988 to 1991.

Three significant changes from the last (1987) review of capital expenditures emerge in the current forecast. The major change noted in the 1988 View is a substantial increase in the forecast of customer demand for both local and toll services. As measured by network access services net gain (NASNG), the 1988 View forecast has been increased over the January 1987 View by 348,700 network access services (NAS), or 34%, for the four common years 1988 to 1991. Also forecast during this period is a 37% increase in long distance message growth. The update to the 1988 View indicates even further increases in the forecast of demand for local and toll services in 1988 and 1989. These significant increases in demand require corresponding increases in capital funding in all years of the 1988 View forecast period. The most significant increase is associated with advanced and enlarged provisioning plans for exchange facilities required to meet the substantially higher demand. Utilization levels are already high, leaving little spare capacity in the network to accommodate increased demand.

Secondly, as a result of ongoing price negotiations with equipment suppliers, there has been a significant reduction of $762.9 million in forecast expenditures for equipment in the 1988 View as compared to the January 1987 View, over the four years common to the two Views. This reduction mitigates somewhat the effects of inflation on overall expenditures.

The third change, noted in the update, is a forecast increase in expenditures in the support category for the years 1988 and 1989. This increase flows from Decision 88-3, in which the Commission denied a proposed accounting refinement relating to real estate.

D. Switching Equipment Modernization - Exchange Program

1. Background

The Switching Equipment Modernization (SEM) program is a central office equipment modernization program to replace analogue switching equipment with digital technology. The forecast expenditures for this program in the 1988 View are as follows:

1988 1989 1990 1991 1992
($ millions/millions de dollars)

140.0 188.8 124.0 140.0 140.0

In its March filing, Bell indicated that it was considering an acceleration of the SEM program. In an exchange of correspondence regarding Bell's projected earnings for 1988, which culminated in Telecom Letter Decision CRTC 88-1, 6 May 1988 (Letter Decision 88-1), the Commission questioned an increase of $116 million in the company's estimated Operating Expenses for 1988 relative to the July 1987 Management Plan (JMP). In particular, the Commission expressed concern about a depreciation expense increase of some $50 million, arising primarily from acceleration of the SEM program (specifically, the replacement of crossbar switches over the next ten years, rather than over twenty years). The Commission stated that the SEM program would be scrutinized in the 1988 CPR and that it would be premature to allow the additional depreciation expense without an analysis in the CPR of the reasonableness of the acceleration.

Guidelines established in 1986 for the SEM program over the period 1989 to 1993 had increased the modernization rate to 316,400 working lines per year. In response to interrogatories, Bell confirmed and outlined its plan to accelerate further the SEM program. The major changes to these guidelines provided for the following: (1) the replacement of a minimum of 450,000 working lines of analogue switching equipment per year; (2) at least 70% (up from 65%) digital penetration in key areas by year-end 1993; and (3) the complete modernization of large crossbar offices by 1996. Bell asserted that these objectives could largely be funded by taking advantage of a volume price discount available from Northern Telecom Ltd. (NTL), commencing in 1988, on its total digital equipment purchases. The company stated that the overall effect of the acceleration on the construction program would be minimal. Bell estimated that the increase in 1988 programs category capital expenditures would be approximately 3% above the levels forecast in the 1988 View. For subsequent years of the forecast period, Bell estimated that the increase would be approximately 9% above the levels forecast in the 1988 View.

Bell pointed out that the advantages of digital technology are related to: (1) economic incentives; (2) improved performance and operations savings; and (3) increased flexibility. Noting that it has fallen behind other major North American carriers in providing up-to-date switching technology, Bell stated that, in future, it will require more flexibility in order to provide subscribers with more efficient and new telecommunications services and to improve network operations capabilities. The company also stated that it wishes to avoid expensive modifications that would be required for crossbar switches remaining in the network. Those modifications would be required because of: (1) the splitting of the 416 numbering plan area in the early 1990s; (2) the introduction of 15 digit international dialling in the mid-1990s; (3) the modernization of automatic message accounting in the early 1990s; and (4) the introduction of call management services (CMS) commencing in 1989.

Bell also provided the results of two economic analyses. One, dated January 1987, indicated a net present value (NPV) of $45.1 million accruing from the acceleration of the SEM rate from 258,100 to 316,400 working lines per year between 1989 and 1993. The other, dated February 1988, indicated an NPV of $0.6 million for advancing the modernization of a typical large crossbar switch from 1995 to 1990. Bell concluded that it would be economically beneficial to accelerate further the SEM program to an average annual replacement level of 450,000 working lines, commencing in 1989. This further acceleration would advance the year of final retirement of large crossbar equipment from 2005 to 1996.

During the review meeting, Ontario requested further information concerning the retirement of switching equipment and the financial impact, particularly on depreciation, of the further acceleration of the SEM program. Bell provided this information subsequent to the review meeting. In response to Ontario's query about central office equipment retirement associated with SEM, Bell indicated that retirements are not tracked by the company according to cause. However, for depreciation analysis purposes, an estimate of the actual retirements in some accounts is made. These estimates are categorized either as "interim", where small amounts of equipment are retired, or "final", where the retirements result from the replacement, through modernization, of a central office switch. However, the company does not forecast retirements by such a breakdown. In 1987, total retirements of step-by-step, crossbar and electronic switching equipment amounted to $98 million, with approximately $90 million falling in the "final" category.

In response to Ontario's question about the actual remaining life of a switch at retirement, the company noted that the replacement of older switches with newer technology is triggered by economic considerations, based on factors such as maintenance savings and space considerations, as well as new capabilities and service offerings. Bell stated that the appropriateness of replacing a switch can be assessed by economic analysis. Bell further stated that it would be possible to operate retired equipment for some further period, but that it is impossible to determine precisely how much longer. Bell emphasized that older equipment is retired and replaced with newer technology only if it is economically advantageous to do so. Thus, from an economic point of view, the remaining life of the retired equipment is zero.

In response to Ontario's request for an assessment of the financial effect of SEM acceleration, particularly on depreciation, Bell noted that no specific economic evaluation study associated with replacing 450,000 working lines annually has been conducted. Therefore, specific details on the financial impact of the SEM acceleration are not available. Bell noted, however, that its previous economic analysis of SEM acceleration indicated a positive NPV of $45.1 million over the fifteen-year study period for an increase in the annual replacement level to 316,400 working lines from 258,100 during the period 1989 to 1993. Bell provided a pro forma income statement and its estimated revenue requirements, incorporating the associated financial effect over the fifteen-year NPV study period from 1986 to 2000. Bell noted that the positive NPV is reflected in a reduced aggregate revenue requirement over that period. The company stated that its economic study does not ignore the effect of increased depreciation, and that changes in depreciation are captured through changes in cash flows resulting from changes in the life estimates of existing equipment and in any capital outlays for replacement equipment. These reflect changes in tax payments, maintenance expenses, salvage and removal costs, and capital expenditures for replacement equipment. In summary, Bell stated that the positive results achieved through SEM acceleration stem from the ability to introduce new revenue producing services earlier, combined with maintenance and other cost savings, and that these benefits more than offset any short-term revenue requirement increase.

2. Positions of Interested Parties

Ontario expressed concern with SEM acceleration, particularly with the advancement of large crossbar switch retirements. While acknowledging that decisions regarding capital investments are the responsibility of company management, Ontario stressed the need for public accountability and expressed the view that proposals for major changes to the expected or planned life of significant capital items should be subject to thorough public review. Ontario stated that management should remove an asset that is not fully depreciated and is still useable only after careful analysis of all related costs and benefits, since subscribers must pay for both the new asset and the undepreciated amount of the retired asset. Ontario emphasized that all of the associated costs and benefits must be considered in order to make the correct decision.

Ontario was not convinced that the company's proposal was adequately supported by analysis. Ontario asserted that proper review was impeded by the company's reluctance to discuss this matter at the review meeting. Ontario submitted that the additional information provided by the company subsequent to the review meeting was inadequate and did not properly address the specific issue of the substantial reduction in the life of crossbar switches. Ontario referred to Letter Decision 88-1, which noted Bell's estimate that SEM acceleration would increase depreciation expense by $53 million in 1988. Ontario submitted that the Commission should not approve the company's proposal to reduce substantially the life of crossbar switches, and that, if the company wishes to proceed, informed public comment on this matter must be permitted. Finally, Ontario recommended that the Commission establish a process that would permit public review of substantial changes of this nature.

In its comments, CAC noted that the company had supported the decision to accelerate SEM with results of economic studies, but contended that these results do not assist in an assessment of the reasonableness of proposed SEM program expenditures. CAC observed that: (1) the adequacy of the economic studies is unknown, since only study results were provided; (2) while the net benefit of the expenditures appears to flow from CMS revenues, the company had, without adequate supporting evidence, assumed a significant penetration rate of 24% for these services, more than twice the actual rate for Custom Calling Features; and (3) the economic study intended to illustrate the economic impact of advancing the replacement of a typical crossbar switch by five years examined only one central office, leaving the company with the difficult task of extrapolating from the specific to the general. CAC noted that, if the company's proposed SEM acceleration was approved, depreciation expenses would increase by amounts of $53 million in 1988 and $35 million in 1989. CAC submitted that the record is inadequate to assess properly the reasonableness of SEM acceleration, particularly in light of its effect on expenses.

3. Position of the Company

Bell disputed Ontario's contention that the company had been reluctant to discuss this matter at the review meeting. Bell stated that full responses to detailed queries were provided at the meeting, that substantial information had been provided in response to interrogatories, and that further details were provided subsequent to the meeting. Bell submitted that its proposal reflects a sound and economic business decision based on factors that were explained in the proceeding. Bell argued that the benefits of its modernization programs have been demonstrated repeatedly, that details on the various programs introducing digital technology have been provided in the 1988 View and that the advantages of an all-digital network architecture have been discussed in this and in previous CPRs. Bell noted that the advantages of SEM are delineated in the record of this proceeding, and submitted that its decision to accelerate the program is prudent and will enable faster realization of the associated benefits. The company asserted that advancing the retirement of large crossbar equipment will also circumvent expensive equipment modifications that would otherwise be required in the 1990s. Bell referred to the results of its previous economic study pertaining to the increase in the annual replacement level to 316,400 working lines and to the financial analysis filed after the review meeting, again noting that the positive NPV over the fifteen-year study period is reflected in a reduced aggregate revenue requirement over the same period. Bell stated that its current opportunity to take advantage of the NTL price discounts implies that the proposed acceleration would have virtually no impact on its total capital expenditures. Bell submitted that its proposal is sound and well supported, and that Ontario's allegation of inadequate evidence should be rejected.

Bell submitted that Ontario's assertion that subscribers pay for both assets, while receiving service from only the new asset, is incorrect by virtue of the principles of equal life group (ELG) depreciation. Bell noted that, if assets are replaced as originally scheduled, their depreciation, based on the ELG method, reflects estimates of expected service lives. As a result, these assets are fully depreciated upon retirement. However, if it is decided to accelerate the replacement of these same assets, their remaining lives are reassessed. Revised depreciation rates are applied under the same ELG method, again resulting in full depreciation at the time of retirement. The depreciation charges for new assets commence only upon the retirement of the replaced assets. Bell emphasized that, as a result, under no circumstances are there concurrent depreciation charges for retired and replacement assets. In response to Ontario's suggestion that major changes, such as the proposed reduction in the life of crossbar switches, should be subject to a further review process, Bell submitted that the CPR, together with revenue requirement proceedings, permits adequate public review. Finally, Bell submitted that Ontario's comments regarding the SEM acceleration proposal should be rejected.

Bell stated that its reply to Ontario's comments applies equally to CAC's submissions. More specifically, in response to CAC's contention that the net benefit of SEM expenditures appears to flow from CMS revenues and that the assumed penetration rate of 24% is not adequately supported by evidence, Bell noted that CAC neither requested further information regarding the assumed rate during this proceeding nor raised the matter at the review meeting. Bell asserted that the penetration rates for CMS and Custom Calling Features are not directly correlated. The company stated that the penetration rate of 11.2% for Custom Calling Features is a 1987 figure. Furthermore, the rate was calculated as a percentage of total NAS, of which only approximately half were capable of providing such services. Bell noted that the penetration rate for CMS is projected for the mid-1990s, and is expressed as a percentage of total lines capable of delivering CMS. Bell therefore submitted that CAC's comparison is invalid.

4. Tests of Reasonableness and Scope of Review

The Commission utilizes a number of tests to assess the reasonableness of various elements of the company's construction program. For projects that are triggered and driven by growth, incremental costs are examined and assessed in relation to the forecast change in demand. In such cases, the Commission expects the most cost-effective method to be chosen. Other projects, generally those within the programs category, are assessed primarily on the basis of an investment analysis and an evaluation of ancillary benefits. Specific programs involving modernization or productivity improvements are also reviewed on an ongoing basis by means of expenditure variance analyses. These analyses include comparisons on a year-over-year, view-over-view and actual-over-forecast basis.

The CPR process was not designed to assess the effect of programs and capital expenditures on depreciation rates and revenue requirement. The Commission is of the view that the scope of the CPR should not be expanded to encompass these issues. The Commission considers that ongoing audit and revenue requirement proceedings provide the most appropriate forum for addressing such matters. The Commission believes that cost/benefit analysis remains the most appropriate method of evaluating planned capital expenditures for non-growth projects. The Commission considers this approach quite adequate for evaluating the capital expenditures associated with major programs such as SEM.

The Commission shares Ontario's view that changes such as the proposed revi sion to the life characteristics of large crossbar switching equipment are very important. However, as explained above, an examination of such changes is beyond the scope of a CPR. In Proposed Revisions to Certain Phase I Directives Concerning Depreciation, CRTC Public Notice 1988-48, 28 November 1988, the Commission initiated a sepa rate proceeding to review the procedu res related to the assessment and approval of depreciation rates and life characteristics. This proceeding provides an appropriate opportunity to address the concerns raised by Ontario.

The Commission closely monitors Bell's financial performance on an ongoing basis. In view of the major technological advances and plant replacement activities that are occurring, and their potential impact on revenue requirement and basic service subscriber rates, the Commission will continue to scrutinize depreciation expense thoroughly.

5. Commission Assessment

The Commission notes that the proposed SEM acceleration to a level of 450,000 working lines annually implies the replacement of about an additional 134,000 lines of crossbar switching equipment annually. The company has stated that this acceleration can be funded largely by exploiting NTL price discounts and that, as a result, programs expenditures would rise above the levels forecast in the 1988 View only by some 9% per year from 1989 through 1992. Therefore, the annual cost of replacing an additional 134,000 lines of crossbar equipment per year should be about $35 million to $40 million. The acceleration of the SEM program would therefore decrease the program's marginal cost per NAS. The Commission sees no evidence supporting the contention of CAC and Ontario that Bell was reluctant to divulge information.

In the view of the Commission, the company's initial acceleration of the SEM program was a sound decision. An analysis of the cash flows related to the first level of acceleration confirms the economic viability of this proposal. There are also a number of technological considerations that favour the advancement of the retirement of large crossbar switches. The proposal to accelerate the SEM program further appears to surpass the basic CPR test requirements for planned non-growth expenditures. The economic evaluation results and financial impact data relating to the first level of acceleration suggest that, in the long term, significant benefits to subscribers will result. The Commission notes, however, that Bell has not undertaken an economic analysis to assess the costs and benefits of further acceleration. The Commission is prepared to find this proposal reasonable, contingent upon further specific economic analysis by the company proving its economic benefits. Accordingly, Bell is directed to file with the Commission and serve on interested parties, by 24 May 1989, data concerning the financial impact and the results of an economic analysis of the acceleration of SEM to 450,000 working lines replaced annually.