Challenging the Spectrum Auction Orthodoxy May 2014

Should auctions always be considered as the right approach for spectrum allocation?

Latin America Spectrum Management Conference, Rio de Janeiro, May 2014

Stefan Zehle, CEO, Coleago Consulting Ltd

Tel: +44 7974 356 258 [email protected]

A specialist telecoms management consulting firm

About Coleago Consulting

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Since 2001, Coleago has offered a wide range of advisory services to the telecom industry

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Completed in 2012 Belgium – 2.6GHz Netherlands – multi-band New Zealand –1800MHz spectrum

trading Switzerland – multi-band Russia – 700MHz & 2.6GHz Pakistan – 2.1GHz valuation Bangladesh - 2.1GHz valuation


Should auctions always be considered as the right approach for spectrum allocation in Latin America?

Challenging the auction orthodoxy


Auctions are the default mechanism for spectrum allocations

Beauty contests were used at the start of the mobile industry growth Difficult to administer, bureaucratic Open to dispute and vulnerable to

corruption

Since 2000 auctions are the norm in spectrum allocations Transparent process (no subjectivity) Policy objective: maximise economic

efficiency In theory, whoever values spectrum

the most will produce the greatest social good


Implicitly, auctions focus on maximising revenue from whatever is sold


Policy objectives for the allocation of mobile spectrum are wider than revenue generation

Promote the highest value use of spectrum

Promote investment and innovation Promote rural broadband access Increase digital participation rates Promote competition Promote customer convenience Provide an appropriate rate of return to

the community

Immediate revenue generation


Allocating spectrum on the basis of private valuations may be at odds with the public good


“The key goal of any auction is to guide goods to those who value them the most. Spectrum auctions help identify the highest value use and users.”

New Zealand Ministry of Business, Innovation and Enterprise - May 2013

“The private value for incumbents includes benefits gained by preventing rivals from improving their services.The value of keeping spectrum out of competitors’ hands could be very high. However, this ‘foreclosure value’ does not reflect consumer value.”

US Department of Justice, Ex Parte Submission before the FCC - April 2013


Spectrum auctions worked fine in past, so what’s different now?

We need to rethink the method of allocating spectrum in the light of maturing mobile markets


Mobile markets have reached the maturity phase of the industry life cycle Many markets show flat, at least in real

terms) or declining revenues and EBITDA

This maturity industry life cycle stage suggest that that policy goals should be revised:– Encouraging new network based

competition is not be appropriate– Taking cash out of the industry is not

sustainable

Maturing markets are characterised by consolidation, not new market entry

Mobile industry consolidation is in full swing The pace and size of cross-border

M&A has been breath-taking, with five mega-deals announced or completed during the past three months.

Markets with consolidation potential include India, Indonesia, Canada, Italy, Germany and Brazil - although regulation is likely to be a constraint in most of these.

Not surprisingly, we are seeing numerous infrastructure sharing deals. Investors should expect further M&A, but at a less frantic pace.


Consolidation is likely in large and small American markets


Given the existing spectrum, new entrants will have too little spectrum to compete

In an LTE world, large contiguous spectrum holdings confer particular competitive advantage The exit of some operators in Europe

and the insolvency of Mobilicity in Canada demonstrates that it is impossible to succeed in the market with small spectrum holdings.

When industry logic has driven consolidation, trying to reverse the process by regulatory is unlikely to produce societal benefits.


Using new spectrum auctions to increase network-based competition is unlikely to succeed

Regulators may wish to consider: Allocating spectrum in a manner which

does not reduce competition while at the same time maximising the benefit of a wide band.

Facilitating a transition from network based competition to other forms of competition.

Focusing on other regulatory remedies if competition is failing, such as a regulated access price offer. The conditions attached to Hutchison Three’s acquisition of Orange Austria can serve as an example.


Consolidation is normal when the industry life cycle

reaches the maturity stage

Wide band allocations are required for an economically and spectrally efficient deployment of LTE

Competition is now the main concern in auction design

At the maturity stage of the industry life cycle we can expect consolidation but not new market entry, at least at network level.

Ensuring competitive markets with the existing number of operators becomes a policy goal.

“In a highly concentrated industry with large margins between price and incremental cost of existing wireless broadband services, the value of keeping spectrum out of competitors’ hands could be very high”. Submission of the United States Department of Justice before the Federal Communications Commission (April 11, 2013)



Alright, we are unlikely to get new network based marketing entry, but why not still have auctions?

Options for spectrum auctions in mature markets


New market entry unlikely

Each incumbent gets a “fair share”, but auction proceeds are

low because there is no real bidding

Set high reserve prices

Unfettered auction among incumbents

Auction proceeds may be high, but increased industry

consolidation and reduced competition results

Spectrum caps to preserve existing competition

Focus on other policy

goals

What then is the point of an auction?

High spectrum prices conflict with other policy goals

High reserve prices are not a good approach to spectrum auctions High reserve prices of auction rules

designed to increase auction revenue have a market distorting effect

Focusing on one policy goal, i.e. to maximise immediate auction revenue will come at the expense of other policy goals

Even if a large amount of money is raised up-front this may reduce overall economic value in the long term


Excessive reserve prices lead to unsold spectrum, such as in the APT 700MHz auction in Australia, May 2013


1.28

0.91

0.58

0.49

0.81

0.56

0.88

0.37

0.65

0.73

1.35

- 0.20 0.40 0.60 0.80 1.00 1.20 1.40

USA - 2/2008

Germany - 5/2010

Sweden - 3/2011

Spain - 7/2011

Italy - 9/2011

Portugal - 12/2011

France - 12/2011

Denmark - 6/2012

UK - 2/2013

Average 700/800MHz

Australia Reserve…

US$ / MHz / Pop

2x15MHz of 2x45MHz unsold

One operator, Vodafone, did not obtain any spectrum and the leading operator Telstra increased its competitive advantage, thus reducing competition

Setting high prices for spectrum is problematic

Hazlett and Munoz, “What Really Matters in Spectrum Allocation Design”, 2010

“[T]he ratio of social gains [is of] the order of 240-to-1 in favour of services over licence revenues…Delicate adjustments that seek to juice auction receipts but which also alter competitive forces in wireless operating markets are inherently risky. A policy that has an enormous impact in increasing licence revenues need impose only tiny proportional costs in output markets to undermine its social utility.

In short, to maximise consumer welfare, spectrum allocation should avoid being distracted by side issues like government licence revenues.”



But why can’t we simply set high prices for spectrum, surely the industry can pay up?

To fulfil societal goals for mobile broadband connectivity, mobile operators require large amounts of spectrum


The GSMA has commissioned Coleago to undertake some initial spectrum requirement estimates for IMT to the year 2020. A report on this work from Coleago is attached indicating the total spectrum required for IMT of 1600 to 1800 MHz for the year 2020. The GSMA believes this is a reasonable number.

Radiocommunication Study GroupsDocument 5D/XX-E, Sep 2012

Extracting high spectrum fees from the mobile industry is not sustainable


Demand for Mobile Broadband and Spectrum

Requirement

Prices Paid for Spectrum

LTE Deployment and Backhaul Capex

Tangible (Network) and Intangible (Spectrum)

CapexRevenue

EBITDA

Free Cash Flow

Impact on Operators Balance Sheet

Return on Capital Employed (ROCE)

EBITDA Margin %

+

=

+

=

When returns drop below the cost of capital, investment ceases to flow into the industry

Cash flows from operations are declining Operators in Latin America have seen

EBITDA margins decline in recent years.

In Q2 2013, the average service revenue EBITDA % margin for Latin America was 34.3% compared to 39.4% in North America and EBITDA cash flows showed a significant year-on-year decline.

Capital expenditure pressure is increasing Capex in the Latin American mobile

industry is set to increase driven by LTE deployment.

However, this is only the investment in tangible assets.

Spectrum capex is a key variable in determining total capex.



How can we do things differently?

2009 AWS auction in Chile focused on stimulating new market entry, but resulted in policy failure

Spectrum caps guaranteed new market entry … A spectrum cap of 60 MHz, effectively

excluding the three incumbent mobile network operators - Movistar, Entel and Claro.

Cable television company VTR won 30MHz of the AWS spectrum paying US$3.02 million, and Nextel won 60MHz, paying US$14.7 million.

Revenue raised amounted to a tiny $0.011 / MHz / pop.

… but failed to deliver timely deployment and competition … The new entrants were unable to

launch their 3G mobile service until May 2012, one and a half years after the October 2010 deadline.

VTR and Nextel together only have 1.3% market share, nearly three years after the AWS spectrum licence award.

… and private investors may pocket the new entrant discount. In a secondary market VTR and

Nextel are likely to sell the spectrum for more than they paid.


The 2014 700MHz licence award in Chile broke new ground and is likely to deliver the policy objectives


The 700MHz spectrum award process focussed on connectivity and competition policy objectives … connect 1,281 rural towns and 500

schools obligation to build fibre mandated MVNO access and roaming

… rather than extracting money from the mobile industry. Auction proceeds amounted to a

relatively tiny 0.017 $/MHz/pop. The reserve price in Australia was set

at 1.35 $/MHz/pop - 78 times higher.

Questions?

Stefan Zehle, MBA

Tel: +44 7974 356 [email protected]

CEO, Coleago Consulting Ltd

Technology

Challenging the Spectrum Auction Orthodoxy May 2014