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Summary

1. This consultation seeks views on a proposed valuation methodology for the reviews of financial terms for Channel 3 licences. Responses are invited by 6 August 2004. Ofcom intends to publish a statement on the results of the consultation, including a decision on the final methodology for the reviews, in September 2004.

Objectives

2. Ofcom hopes to achieve three policy objectives through the proposed methodology that is set out in this document. First, Ofcom intends to determine a fair value for each licence, within the framework of the statute, and to set licence payment terms according to a proportionate and objective process. To the extent possible, the process should allow Ofcom to set payments that are reasonable within the context of the current market environment and that will continue to be reasonable for the full period of the licence. Second, Ofcom aims to improve the clarity and transparency of financial reviews by providing applicants with more information and guidance prior to the application date than was provided in the past. Third, Ofcom proposes to simplify the application process by reducing information requirements and providing licensees with greater assistance with the application process. In order to promote a more clear and consistent regulatory environment, Ofcom agreed earlier this year to offer Channel 3 licensees the opportunity to align their review dates.

Statutory requirements

3. Section 225 of the Communications Act 2003 (the Act) allows for Channel 3, Channel 5 and Public Teletext licensees to apply to Ofcom for optional reviews of their financial terms for payments to the Treasury.

4. Separately, the Communications Act requires Ofcom to offer to replace the existing analogue broadcasting licences with digital broadcasting licences prior to 29 December 2004. The digital licences will be, primarily, licences to provide a service on a digital terrestrial multiplex with a requirement to simulcast the service in analogue. In accordance with the statute, the existing financial terms will carry forward to the new digital licences and will remain in force until licensees apply for reviews.

5. Under the Act, the earliest date on which a licensee can apply for a review of its financial terms is four years prior to the expiry date of its analogue licence. Following a consultation earlier this year, Ofcom decided to offer Channel 3 licensees the opportunity to align the expiry dates of their analogue licences and, therefore, the dates for their reviews. As a result, Channel 3 licensees will be allowed to apply for reviews from 31 December 2004.

6. Under Section 227 of the Act, following an application for a review, Ofcom must determine a fixed annual cash amount to be paid for the licence and a percentage of qualifying revenue payable for each year of the licence period. Specifically, the Act requires that Ofcom determine the amount that, in its opinion, would have been the cash bid of the licence holder were the licence being granted afresh. This means that Ofcom is required, in practice, to reproduce the effects of a hypothetical auction of the licences.

7. The Act requires Ofcom to conduct a review of public service broadcasting (PSB), which is due to be completed later this year. The timing of the financial reviews will allow Ofcom to reflect in the new financial terms any changes to licence holders' public service obligations that may result from the PSB review.

Context

8. Ofcom believes that it is important to take account in the valuation methodology of the fact that the regulatory environment for broadcasters has changed significantly since the auction of the Channel 3 licences in 1991 and since the original methodology for financial reviews was developed by the ITC in 1998. In particular, regulatory reform has led to a less intrusive regime for broadcasting licensees. For example, more responsibility is being passed to licence holders with regards to complying with public service broadcasting obligations. Also, restrictions on ownership of multiple licences have been eliminated, and there has been large-scale consolidation of Channel 3 companies. The foreign ownership restriction has also been lifted, allowing foreign companies to acquire Channel 3 licences. The licensing regime will also change at the end of 2004 when the new digital licences replace the existing analogue licences. Ofcom has taken account of these changes in reviewing the approach that should be taken to setting financial terms.

Detailed proposals

9. The Act is not prescriptive about the specific process that Ofcom must follow in order to determine the amount that would be bid for each licence in a competitive tender. Therefore, it is necessary for Ofcom to establish the circumstances of the hypothetical auction process that Ofcom aims to replicate in the reviews and the corresponding valuation methodology.

10. Ofcom proposes that the hypothetical auction would replicate the following circumstances:

• As required by the Broadcasting Act 1990, Ofcom would design a sealed-bid auction in which the highest bidder would win the licence.
• The auction would be designed, within the framework of the statute, to recover the maximum possible value consistent with the highest bidder being able to fulfil all of the programming and other obligations associated with the new digital licence.
• Licences are likely to be most valuable when held as a group because this offers the greatest opportunity for efficiency. Therefore, as far as it is possible, Ofcom would offer the licences simultaneously. Ofcom would also allow contingent bids for multiple licences, as there are no longer ownership restrictions preventing this.
• The amount the incumbent would bid in a competitive auction would be the minimum required to beat the second-highest bidder, and as such would not necessarily represent the maximum amount the incumbent would be willing to pay. The difference between the value of the licence to the incumbent and the value of the licence to the second-highest bidder should equal approximately the cost of entry.

11. On this basis, Ofcom proposes to value each licence and set the financial terms as follows:

• Ofcom considers that the value of the licence to a bidder would equal the net value of the rights and obligations associated with the licence.
• In order to determine the amount of the second-highest bid in an auction, Ofcom proposes to estimate the net present value of the licence to the incumbent and then adjust this value downwards to reflect the additional costs, e.g. start-up costs that a new entrant might incur.
• Without a Channel 3 licence, a broadcaster could not provide an analogue service. Therefore, all profits made from providing an analogue service can be attributed to the licence. Ofcom proposes to value the analogue element of the licence by using a discounted cashflow forecast to estimate the present value of the expected cashflows attributed to the analogue service over the relevant period.
• In order to forecast cashflows for the analogue service, Ofcom will need to allocate costs and revenues that are common to the analogue, digital terrestrial, cable and satellite services. Ofcom believes it may be most appropriate to base the allocation on the expected percentage of viewing on each platform. This would be a change from the past approach of apportioning common costs and revenues on the basis of the percentage of households with digital receiving equipment.
• In order to reflect the current market and regulatory environment appropriately, Ofcom proposes to take account in its forecasts of the benefits of common ownership of licences. Ofcom believes that the second-highest bidder in a competitive auction would bid for multiple licences and would reflect the cost efficiencies in its bid. This approach differs from the past approach of valuing each licence as though no other licences were held.
• Based on its own analysis, Ofcom proposes to use a real, pre-tax discount rate of 12% for all licence valuations. This is an increase from the 10% rate used in past valuations.
• Ofcom considers that it must also take account in the licence valuations of the net value of the rights and obligations associated with the digital terrestrial element of the licence. However, Ofcom's preliminary view is that the net value is unlikely to be significant.
• A broadcaster does not need a Channel 3 licence to provide a digital terrestrial television service, as this right can be replicated by obtaining a digital programme service licence and negotiating for carriage on a digital terrestrial multiplex. Therefore, it would not be appropriate to attribute all of the profits from the digital terrestrial service to the Channel 3 licence. Instead, the value of the digital terrestrial rights would equal the cost savings to the licence holder from not having to obtain the rights elsewhere.
• Ofcom proposes to take into account the present value of the net costs associated with meeting the public service broadcasting obligations and any obligations related to digital switchover that are imposed by the licence.
• In the past, the ITC aimed to recover approximately 75% of the surplus value of each licence via variable payments based on qualifying revenue (the PQR payments) and the remaining 25% via the annual fixed cash sum payments. Ofcom proposes to reconsider the split between the PQR and cash sum and invites views.

The text of the full document is available in PDF format via the link on this page.

Consultation on methodology for reviews of financial terms for Channel 3 licences

• Consultation on methodology for reviews of financial terms for Channel 3 licences [pdf]

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