Economic Impacts of Spectrum Auctions

Radio spectrum is a peculiar asset. It exists, it is continuously renewable, under certain circumstances it can even be shared. If its use is uncontrolled there is ample opportunity for impairment of services which exploit the resource. There is good reason to believe that eventually -- but not anytime soon -- that with more agile and intelligent technology, sharing and optimization can be largely automated. For the present we need regulations and licensing to allocate spectrum to specific users and how it's used.

Up until the mid-1990s the commercial and technological requirements for mobile phone spectrum was quite modest. The number of users was comparatively small and analogue voice technology was amenable to fairly uncomplicated channel management protocols. Governments tended to assign spectrum licenses to a select group of companies, and used those licenses as a tool to either further strengthen incumbent carriers -- some that were owned in part by the same governments -- or to foster competition by splitting spectrum among several companies with the demonstrated wherewithal to build a sustainable business.

Then came the idea that spectrum is a national asset that can be assigned a market price and can therefore be leased to competing entities by means of open auctions. Always ready to open the treasuries to new revenue streams, especially revenue not derived from broad-based taxes, the politicians listened and made it so. This idea was implemented with enthusiasm in the US, where they raised many billions of dollars. Canada and other countries picked up on the idea and spectrum auctions spread across the globe. Governments enjoyed the windfall of the wild bidding wars that ensued, and their populations liked the idea that taxes could be avoided even while expanding public services with this new revenue source. Of course nothing is ever that clean and simple: there is a public cost, even though it is sufficiently disguised to fool many people.

Besides the specific problems that they raise, spectrum fees share one big problem with auctions: They can too easily be used as cash cows. Experience shows that the government always needs more money, in booms and in recessions. Nearly $6-billion has already been earned by the federal government in auction proceeds, and $130-million is paid in annual spectrum fees at current rates.

Even at $130M annually these annual spectrum fees are not onerous. If we assume 24M mobile phone users in Canada, that works out to about $0.50/month/subscriber. That isn't much, even if it is annoying, and it is hidden in the price of service. Yes, you and I are paying those spectrum fees indirectly since, as with all input expenses, they are calculated into the price of the service.

This is fair; the carriers are businesses and they should be free to recover their expenses and earn a profit. Except that what we have here is a type of hidden government tax, where the government charges the carrier that then recovers the cost from subscribers. Unlike the fake fees the carriers are so fond of loading onto phone bills, this is a real cost of doing business that is imposed by the government. Unlike manufacturers and excise taxes that were replaced by the GST two decades ago, in part to make explicit to consumers those previously "hidden" taxes, spectrum fees are a current hidden tax on us.

While the annual spectrum license fees are small, that is not true of the basic licenses themselves. As the article pointed out, this amounted to a one-time fee of $6B. That works out to $250/subscriber (this is a grossly simplified model, though sufficient for the present discussion). This is amortized over a longer term than the annual fees so that, assuming a 10-year term (for planning purposes), it works out to $2/month/subscriber. This is beginning to become a significant portion of the prices we pay, and it get worse. First, the $6B must be paid up front once the auction is concluded (or sometimes in payments over a year or two) and in most cases the winning carriers must borrow to pay for the licenses. Just like with mortgages, the final cost can be substantially more than the original spectrum license fee. This is accounted for in the carriers' actuarial calculations so that the prices they charge us also cover their borrowing costs.

There is more. The way in which the government conducts the auction affects the development of competition, or the lack of it. This happens in two distinct ways, which I'll cover in turn. First up, which companies can bid for spectrum.

Rogers Communications Inc. chief executive Nadir Mohamed urged Ottawa to speed up plans on a key auction for new airwaves while saying federal officials must ensure the bidding does not disadvantage "made-in-Canada companies" like Rogers.

"In the last spectrum auction, the government restricted who could bid . . . existing customers were disadvantaged and unable to bid on certain blocks of this spectrum. This can't happen again," he told business leaders during an address to the Economic Club of Canada on Wednesday.

Here we see how governments restrict which companies can bid in spectrum auctions in order to enable competition. Unlike with wired telecommunications where incumbents have a dreadful advantage over new entrants, the playing field in wireless is fairly amenable to policies of this sort. An additional benefit of restricted auctions of this type is that the winning bid is likely to be lower. When the financially-stronger incumbents are kept out, the new companies are less likely to run up the price in a bidding frenzy; they all have somewhat similar financial realities and can be expected to bid in accordance with that reality. This keeps the spectrum license fees lower and, at least in theory, allows the new entrants to keep their prices lower than older companies that may have paid more in open auctions.

Yet even so not all is well, as we discovered back in the 1990s. New entrants such as Microcell (the original Fido) were eventually acquired by the incumbents, and the same can occur again. Lower spectrum license fees due to a restricted auctions are only relatively lower; they are still very expensive for a company starting with no revenue and about to embark on an expensive network construction project. All of this must be financed and it leaves these companies vulnerable to business hiccups, increasing interest rates and revenue downturns due to price competition.

If the incumbents are allowed to bid on new spectrum, the new entrants will typically find themselves paying more for the licenses they do win. We should expect that the hungry and stronger incumbents will bid aggressively. They win whether they win or lose the auctions: if they win the auction, competition is avoided and they can raise prices to their captive market to recover the cost of the newly-acquired licenses; if they lose the auction, they have driven up the license fees by participating in the auctions so that their competitors are thus more likely to fail or to fail sooner due to the increased financial burden. We lose because, no matter which carrier wins the auctions, we will be charged higher prices to compensate for their spectrum costs.

[Pierre Peladeau, CEO of Quebecor says,] Predictably, the same incumbent voices that opposed an equitable distribution of spectrum in the last auction can once again be heard calling for an auction devoid of any rules that could hamper their dominant role in the market.

The second impact of spectrum auctions is a little more subtle, but just a little. Although the carriers must pass on their license fees to customers, there is also a limit to how much they can load our bills in a competitive market. Higher costs due these auctions led to higher prices and, importantly I think, slower network builds. There is only so much capital intensity a company can withstand before compromises must be made. If you can't raise prices you must slow network investment. If you do raise prices, you slow the pace of customer acquisition or you market service more toward business subscribers. Gaining subscribers when you are new to market and are in the midst of building a network is never easy as, for example, Wind Mobile and Quebecor are discovering.

I believe this is one of the reasons why Europe, Japan and some other countries were able to grow their wireless markets faster than the US and Canada in the previous decade and a half. Saddled with heavy debt from both capital expenditures and spectrum licenses, new carriers here have a disadvantage to create competition. In the absence of healthy competitors, the incumbents can keep prices high and not particularly care about rapid innovation or expansion.

As far as public policy goes on spectrum auctions, the government is sacrificing telecommunications infrastructure and the economic activity it would create for the immediate gratification of money in the treasury. As citizens, we have largely bought into this bad bargain, and we are paying the price. Except that the price is extracted from us in the form of high mobile phone bills rather than direct taxation.

I recall one time, many years ago, I inadvertently stumbled into this debate in a meeting with senior FCC staff. It turned out that the most senior person there had been deeply involved in selling the idea of spectrum auctions to Congress. Let's just say that I quickly discovered the political investment that the government had put into this policy instrument and that they didn't take kindly to criticism. The thing is that at first blush it really does seem like a good policy, but I believe as fervently now as I did then that it is a bad policy that costs all of us more money and poorer services and choices than alternatives.