IDEE Telecom Conference June 11 1999: Spectrum Valuation and Pricing The UK Approach to Spectrum Pricing and Auctions

The paper discusses the need for a new generation of spectrum management tools to cope with the challenges facing spectrum managers into the 21^st century. It describes the UK’s approach to the introduction of spectrum pricing, with particular reference to the UK’s pioneering work to develop administrative spectrum pricing methodology, and looks ahead to future developments beyond spectrum pricing.

The author

The author is Head of the UK Radiocommunications Agency Strategy Unit. The Radiocommunications Agency, which is an ‘executive agency’ of the UK Department of Trade and Industry, is responsible for managing most non-military radio spectrum in the UK and for representing the UK in international discussions on radio matters. Laurence Green has been closely involved in the development of policy on market-based spectrum management tools; the formulation and passage through Parliament of spectrum pricing legislation; and the subsequent implementation of spectrum pricing. Contact details: tel:+44(0)171-211 0566; fax:+44(0)171-211 0571; e-mail: laurence.green@ra.gsi.gov.uk

For Agency publications referenced in the paper:

• telephone:+44(0)171-211 0211
• fax:+44(0)171-211 0507
• e-mail: library@ra.gsi.gov.uk
• internet: www.radio.gov.uk

 The UK Approach to Spectrum Pricing and Auctions

The radio spectrum is a finite resource of considerable and fast-growing economic importance. It has been estimated that, in 1995-96, spectrum-based industries directly accounted for 0.5% of UK gross domestic product and employment generated £12-15bn consumer and competitiveness benefits. The recent Commission Green Paper on spectrum policy emphasised the strategic economic importance of spectrum to the EU as a whole.

Failure to make the best possible use of the spectrum resource can impose substantial costs, including loss of international competitiveness. These could amount to billions of £s. Effective management of the spectrum resource is therefore of great importance to building the knowledge driven economy.

Although national circumstances differ, administrations worldwide face broadly similar spectrum management challenges. Demand for frequencies is increasing, especially in bands suitable for mobile communications. At the same time, technical and market developments, such as convergence, are accelerating in unpredictable ways and new types of service are constantly requiring access to spectrum. The challenge for spectrum managers into the 21^st century is how to satisfy demand for spectrum that is simultaneously growing quantitatively and changing qualitatively. Unless that challenge can be met, there is a real danger that spectrum congestion and shortages will hold back growth and slow down innovation.

Since the development of radio as a communications medium at the turn of the present century, spectrum managers have generally relied solely on regulation to manage spectrum and licence fees have tended to be set no higher than necessary to recover administrative costs.

This worked reasonably well while spectrum was plentiful, technology relatively stable and demand could be met on a ‘first come-first served’ basis. But, as demand has grown and change has accelerated, the Agency is having to make increasingly difficult spectrum management decisions at the allocation and assignment levels. It has become apparent that, in some cases, regulation, despite its advantages, is no longer sufficient by itself and needs to be augmented. This is for two reasons.

1. The Agency inevitably has less information than those directly involved in providing services and products about the benefits of alternative uses of spectrum and changes in future demand. Consequently, there is a real risk that its regulatory decisions may not lead to the most advantageous outcome.
2. The requirements of administrative law and the EU Licensing Directive mean regulatory procedures tend to be time-consuming and inflexible. This can make it difficult to adapt at a time of rapid change. The optimal distribution of spectrum will shift as circumstances change. Regulation is unlikely to be able to adjust sufficiently quickly on an ongoing dynamic basis.

Some or all of the following harmful consequences could result.

• Spectrum management decisions are imposed by administrations on the basis of incomplete information about future trends.
• Slow administrative procedures for changing spectrum allocations and assignments retard technical progress and innovation.
• Users have little incentive to give up unused or under-utilised spectrum or to invest in more spectrum-efficient technology or services. This creates a self-perpetuating circle of shortage and hoarding. If licence fees do not reflect the economic value of the spectrum, users have an incentive to retain surplus spectrum in case they need it later, which exacerbates the shortage. Hoarding can in principle be prevented by regulation but, in practice, this is difficult.
• Spectrum is not assigned to the highest value user or use and investment decisions are distorted leading to misallocation of resources. For example, a telecommunications operator may decide to retain high capacity radio fixed links in its trunk networks instead of installing cable. This may be cost-effective from the operator’s point of view but may not represent the most beneficial use of the spectrum for the economy as a whole.
• Regulation imposes hidden, but sizable, compliance costs and denies users the right to make informed choices about how best to meet their communications needs. The regulator’s dictat is a blunt tool. Users have to comply with inflexible standards whether or not they make economic sense in their own individual circumstances.

The UK, like several other administrations, is therefore making increasing use of market-based spectrum management tools, such as spectrum pricing. These work through the market and apply market-players’ private information to help achieve the optimal outcome in terms of spectrum distribution and are capable of responding dynamically to changing circumstances. It is important, however, to emphasise two key points.

The first is that market forces are being used as a complement to regulation, not a complete substitute. It would not be desirable to allow market forces total freedom. Regulation will continue to play a central role in managing radio spectrum in order to:

• give effect to harmonisation and frequency coordination within the ITU, CEPT and EU frameworks;
• deal with interference and unlicensed use;
• ensure effective competition and maintain diversity, including access to spectrum by small businesses;
• guarantee access to spectrum to meet the operational needs of essential public and safety-of-life services.

Regulation and market-based tools are being combined in the UK in a pragmatic manner. Different radio services have different characteristics and may require different approaches. Thus a combination of administrative pricing and regulation is being used to manage spectrum for most mobile radio and point-to-point fixed links, Third Generation mobile telecommunications spectrum is planned to be auctioned while regulation alone will continue to be sufficient for some other licence classes.

The second point to stress is that solutions adopted in the UK will not necessarily be universally applicable. National circumstances, such as the balance between spectrum demand and availability in particular frequency bands and the pace of market change, will differ from country to country and will affect the selection of spectrum management policies. The UK strongly advocates on the principle of subsidiarity that each country should be free to adopt the spectrum management tools, or combination of tools, that best suits its circumstances and priorities, provided that this is done on a non-discriminatory basis and reflects the need to ensure optimal use of radio spectrum.

Spectrum pricing may be defined as charging fees for access to spectrum that reflect its value. The Wireless Telegraphy Act 1998, which entered into force in June 1998, substituted spectrum pricing for cost recovery as the basis for setting radio spectrum licence fees in the UK.

This approach is in line with standard economic theory that the distribution of a scarce resource, such as spectrum, will be optimised in terms of economic welfare if it is priced at its marginal value, thereby ensuring that it is assigned to those who can achieve most benefit from its use. If it is priced below this level, those who generate less benefit have little incentive to relinquish it in favour of those who can add more value; and businesses, consumers and jobs suffer. It is also likely that fees charged to recover costs will discriminate unfairly against small business users as the cost of administering a licence is unrelated to the amount or value of the spectrum occupied.

In accordance with article 11.2 of the EU Licensing Directive, it is a cardinal principle in the UK that spectrum pricing should be used to achieve spectrum management objectives, not to maximise licence revenue. Since other EU member states are also subject to article 11.2, the transposition of this provision into UK law and its mode of application may be of wider interest.

The Act introduced two forms of spectrum pricing:

• auctions, in which fees are set directly by the market; and
• ‘administrative pricing’, in which fees are set by regulation on the basis of spectrum management criteria.

The legislation was preceded by widespread public consultation, including a consultative document , White Paper and a study of the application of spectrum pricing. This consultation demonstrated widespread support for spectrum pricing in principle and helped construct consensus for reform. There has since been further extensive consultation on detailed implementation.

Compared to the alternative of comparative selection, auctions offer important advantages of:

• economic efficiency. A well-designed auction ensures that licences are awarded to operators that value them most and can generate greatest economic benefit;
• fairness. Selection by administrative criteria is more subjective and less transparent;
• being less unfavourable to new market entrants. Comparative selection tends to favour incumbents with established track records.

However, auctions are not suitable in all circumstances. For example, they would be impracticable for high volume-low value licences for private business radio used by taxis or individual fixed links. The Government has made clear that auctions will be used selectively in the UK for new national or regional services where there are more applicants than can be accommodated in the spectrum available. Existing operators will not be required to enter a spectrum auction for the right to continue their existing services within existing allocations. Nor will broadcasters who have won their broadcasting franchises in an auction under the broadcasting legislation be required to enter a spectrum auction.

The new Third Generation mobile telecommunications services appear to meet the general criteria set out by Ministers and preparations to auction spectrum licences in the UK are well advanced. On 6 May 1999, UK Telecoms Minister, Michael Wills MP, confirmed the Government’s intention to auction spectrum licences for the new Third Generation of mobile telecommunications. He announced that, following extensive consultation with the industry, it had been decided to offer five licences for different amounts of spectrum - three for 2x10 MHz plus 5 MHz unpaired, one for 2x15 MHz and one for 2x15 MHz plus 5 MHz unpaired. The largest will be reserved for a new market entrant.

The Government expects that, subject to market and other developments and to final decisions nearer the time, the auction will take place in the second half of the 1999-2000 financial year.

Provided there is sufficient demand for the licences, an auction offers two main advantages over administrative pricing. First, it will enable the licence fee to be set directly by the market instead of having to be estimated. Second, it will select the operators who can make the most valuable use of the spectrum. Administrative pricing could still require some form of comparative selection procedure, with the associated disadvantages.

Experience shows that auction design is critical to a successful outcome. The design of the Third Generation auction has been subject to careful consideration with the help of experts in Game Theory and extensive consultation and has been tested experimentally. The basic design is a simultaneous multi-round auction with a ratcheted reserve price to ensure that the price paid for the licence reserved for a new entrant is not disproportionate to that paid for the other licences. The simultaneous multi-round design is well-adapted to achieving an economically efficient outcome because bidders gain information during the bidding about others’ valuations and can adjust their strategy accordingly. Full details are available on the Agency’s website.

As mentioned above, an auction should achieve greater economic efficiency by selecting operators that can make best use of the spectrum and greater speed and certainty in the selection process. The particular design chosen in the UK will promote innovation and competition by providing for at least one new market entrant.

It has been suggested that an auction may increase operators’ costs, slow down development of Third Generation services and lead to higher prices for consumers. Economic theory and experience in countries that have auctioned licences do not support these concerns.

An auction is not a ‘licence to print money’ for the Government. Bids will be determined directly by bidders’ own valuations of the worth of the spectrum. In a well-designed auction, the winners will be those that can derive most benefit from the licences. This, plus competition, will encourage them to roll out networks more quickly to recoup their outlay. Bidders will take into account the costs they face, of which the spectrum fee is by no means the largest element, and should not bid more than they can afford.

As far as prices to consumers are concerned, these will tend to be determined by the demand curve for Third Generation services, not by the costs of inputs, such as spectrum. If operators attempt to increase charges above a certain level, demand and revenue will both fall. Bidders can be presumed to have incorporated in their business plans forecasts of demand at the tariffs they propose to charge; and can be expected not to make bids that would require them to overprice their services in order to earn a commercial return on their investment. In a competitive market, such as will exist for Third Generation, competition will effectively discourage both overbidding and overcharging.

Administrative pricing involves the spectrum manager in setting the level of licence fees as a surrogate for market forces. Most licence fees are set by administrative pricing rather than auctions.

The 1998 Act requires the Secretary of State, in setting spectrum licence fees, to have regard in particular to various spectrum management factors. These are:

• the balance between spectrum availability and current and expected future demand; and
• the desirability of promoting:

• efficient spectrum use and management;
• economic benefits;
• development of innovative services; and
• competition.

The legislation therefore ensures that spectrum pricing cannot be used as a form of taxation. Indeed, the Act ended the statutory requirement for licence fee regulations to be approved by the Treasury. Under proposals for administrative pricing in the UK, although some users with exclusive national channels or assignments in parts of the country affected by congestion will pay higher fees, tens of thousands of smaller business users will pay no more than previously or will benefit from fee reductions. Even where fees are increased, they will be no higher than necessary for spectrum management purposes.

It also follows that spectrum pricing is being applied in a focused way. Spectrum pricing is not an appropriate tool in some circumstances. For example, the use of spectrum pricing is not normally indicated where spectrum is not congested or technical standards, such as bandwidth and frequency, are mandated by international regulation and users cannot respond to price signals by adopting alternative technology.

A brief account of the UK’s methodology for setting licence fees may be of interest. A fuller description may be found in the documents referenced above. To the best of the author’s knowledge, this methodology is unique to the UK in the way that it seeks objectively to quantify the marginal value of the radio spectrum. Although it is necessarily an approximation to the true value of the spectrum, which cannot be calculated with absolute precision, it is a considerable advance on other methods based on allocating spectrum management costs or an arbitrary revenue target.

Ideally, administrative pricing would result in fees equal to market clearing rates that balance supply and demand for spectrum. In practice, it is extremely difficult to estimate this rate. In a competitive market, such a fee would equate marginal costs to marginal benefits. Since profit-maximising firms would use spectrum only if their marginal benefits exceed their marginal costs, ie the administrative pricing fee, the task of the Agency is to set a licence fee that reflects the cost to the economy of their spectrum occupancy.

Where there is congestion, this cost is principally the unrealised cost savings of those who are excluded from using the spectrum. This opportunity cost is the difference between the cost of using the frequency in question and the cost of the least expensive practicable alternative to the existing assignment. That alternative may be another service, frequency band, technology or medium, such as cable.

A number of possible methodologies are discussed in the literature, including the user’s revenue or profitability. But these do not necessarily optimise the allocation of spectrum. The amount a user can afford to pay is not necessarily an indicator of the value of the activity to the economy, especially if radio contributes a relatively minor part of its activities. There may also be practical difficulties in gathering data on profits. Nevertheless, comparisons with revenues and profits are helpful in putting into perspective the effect of revised fees on users and have been used to demonstrate that the UK’s spectrum pricing proposals should not result in significant price increases for consumers.

The UK methodology may be summarised as follows.

1. Define alternatives to the current assignment For example, in the case of private business radio used by taxi firms, couriers etc the use of narrowband technology, trunked systems, more efficient sharing and re-use and moving to a different frequency band.
2. Cost the alternatives over the lifetime of the equipment The additional cost of the cheapest alternative compared to current radio costs (in the example quoted above this was a move to trunked systems) provides a measure of the marginal value of the spectrum for the application in question. In the case of mobile radio, the marginal values differed between services and an average ‘Spectrum Tariff Unit’ is being applied to all mobile radio in the interests of fair competition. This amounts to about £1.65/MHz/km².
3. Derive licence fees from the marginal value of spectrum on the basis of pre-selected parameters. In the example of private business radio, those proposed are bandwidth, coverage area and the degree of sharing as indicated by the number of mobiles as a proxy for traffic generated. Location is also taken into account with higher fees in congested areas. Congestion is quantified on the basis of a formula for each cell in a grid of 10 km x 10 km squares covering the whole country, leading to the definition of three charging regions: central London, which is heavily congested, Birmingham, Manchester and Liverpool, which are congested and the rest of the country, which is uncongested. Fees for exclusive regional and national channels can also be derived.
4. Apply ‘modifiers’, ie numerical factors to take account of various spectrum management factors, such as competition, choice and diversity, quality of service and spectrum usage constraints. For example, spectrum above 1 GHz is considered less valuable than spectrum below that frequency because of its propagation characteristics.

The new regime is being implemented in three waves, each phased in over 4 years so that users have an opportunity to adjust, as follows.

• The first wave of administrative pricing, which began in July 1998, tackled the worst distortions of the previous cost-based regime by increasing fees for mobile telecommunications networks and reducing them for thousands of users of on-site private business radio.
• The second wave, planned to start in July 1999, will extend spectrum pricing principles to other mobile radio and point-to-point fixed links. Fees for national telecommunications networks will continue to increase but smaller private business radio users will continue to benefit from fee reductions outside congested areas.
• The third wave, due to commence in July 2000, will cover other licence classes, including broadcasting, which raises special issues as some broadcasting franchises, as opposed to spectrum licences, are already auctioned.

This will also enable the effects to be monitored and licence fees to be modified if necessary to achieve the desired spectrum management objectives.

The Agency has published detailed Regulatory Impact Assessments for the first and second waves of administrative pricing. These documents analyse the business sectors affected and the costs and benefits of the new policy with particular reference to small businesses. For the second wave, the Agency estimates that:

• over 60% of the current 57,000 private business radio licensees will pay no more than at present or enjoy fee reductions of up to 65%;
• the fee increases for a small private business radio user, such as a taxi company, that will pay more would be no more than 8p per taxi per week;
• the increase for a mobile telecommunications network would amount to just 5p per subscriber per week and even this modest amount may not be passed on to subscribers in view of fierce market competition;
• the potential economic benefits from the greater spectrum efficiency spectrum pricing should promote would far exceed the costs to business of the additional licence revenue.

As can be seen, planned fee increases are modest. The figures convincingly demonstrate that spectrum pricing in the UK will not make radio too expensive for businesses to afford.

It has been a consistent feature of UK policy that the public sector, including the armed forces and emergency services, should be charged for spectrum on a comparable basis to the private sector. The public sector is a major user of spectrum. For example, the armed forces occupy more than 30% of the spectrum between 9 kHz and 30 GHz. It is seen as important that the public sector should also have incentives to use spectrum more efficiently and this has been a key factor in securing general acceptance of spectrum pricing.

Comparability is being achieved through the application of administrative pricing principles to public sector users, including the armed forces. The details of how public sector spectrum will be valued are under negotiation with the other Departments concerned but the principle is established as an essential component of the new regime.

Spectrum pricing is envisaged as operating within the framework of existing allocations. However, marginal spectrum values may be used as an indicator of adjustments to allocations that could realise economic benefits. For example, if the marginal value of spectrum for one application is much higher than that for another use, this could indicate that it would be advantageous to allocate more spectrum to the former. Economic methodology could therefore play a role at the allocation level. It is not suggested that it should be the sole determinant but, equally, it would not be prudent to ignore it completely.

The creation of a spectrum market to enable users to trade spectrum between themselves instead of having to be directly licensed by the Government would be a logical development of spectrum pricing. It would provide an increased incentive to relinquish surplus spectrum and an additional mechanism to help new services gain access to spectrum more quickly. This would be a considerable advantage at a time of rapid and unpredictable change. Spectrum trading has already been successfully introduced in Australia, New Zealand and the USA and is expected to be introduced in Canada.

Spectrum trading covers a range of possibilities, from straightforward change of ownership of an assignment with no change of use to more advanced variants in which assignments may be divided or amalgamated and use changed. Not all of these are equally suitable for all services and some may be better suited to exclusive national channels than to shared local assignments.

There would need to be an effective regulatory framework to provide certain safeguards, for example to ensure compliance with international requirements, to prevent interference, to maintain competition and to protect access to spectrum by small firms and essential services. For example, transactions could have to be notified to the spectrum authority, which would have a power of veto.

Fuller details of the thinking underlying spectrum trading may be found in a consultative document issued at the end of last year. The responses showed strong support in principle for the introduction of spectrum trading. The Agency is developing detailed proposals in consultation with industry but their introduction would require amendments to be made to the Licensing Directive. In its current form, the Directive has the apparently unintended effect of severely limiting spectrum trading. It is hoped that the Directive will be amended to allow member states that wish to do so to introduce spectrum trading.

The economic costs of failing to accommodate growing demand for spectrum could be considerable. Meeting future demand will require new market-based spectrum management tools to complement regulation, although regulation will continue to be necessary and play a key role.

The UK is already introducing spectrum pricing in accordance with the following principles.

• Spectrum pricing is not a tax. Licence fees will be no higher than necessary for spectrum management purposes. .
  
• Auctions are being applied selectively. .
• Administrative pricing will be focused and affordable, including by small businesses.

• Public sector users will pay on a comparable basis to the private sector for spectrum.

Subject to changes to the Licensing Directive, spectrum trading would be a logical development of spectrum pricing and could play a useful part in making spectrum available for innovation and growth.

Choice of spectrum management tools will depend on national circumstances. Each country should have flexibility to adopt the spectrum management methods it deems appropriate, provided that this is done in a way that is non-discriminatory and reflects the need to make optimal use of the finite spectrum resource.

8 June 1999