2 Objectives of the renewal process

Background

2.1 In June 2004, the Government confirmed the following objectives for the process for renewing spectrum rights.1

1. That commercial spectrum rights be reallocated five years before expiry for a further 20 years, subject to review on a case-by-case basis to ensure consistency with New Zealand’s international radio obligations and with the general objective of maximising the value of the spectrum to society as a whole;
2. That the Crown should receive a fair financial return for the use of spectrum in the future period; and
3. That spectrum rights be reallocated to existing right holders based on price-setting formulae that estimate the market value of the rights, and that if existing right holders do not wish to pay this price, the respective rights be reallocated by auction.

2.2 At the same time, the Ministry of Economic Development was asked to recommend a suitable price setting formula, which would approximate the market value of spectrum rights, be administratively simple and be applicable in a transparent manner.

2.3 Covec Limited developed a price-setting formula for the Ministry (“the Covec methodology”) based on the principle of applying a constant escalation factor (“z” or the “z factor”) to original prices bid in tenders or auctions for the spectrum rights. This approach was peer reviewed by PricewaterhouseCoopers. With various amendments2 the Covec methodology has been applied to the renewal of UHF TV licences and is currently being applied to the renewal of AM and FM radio broadcast rights.

2.4 At the time of the development of the Covec methodology, both Covec and PricewaterhouseCoopers raised concerns about the suitability of the Covec methodology for setting prices for spectrum rights for cellular. These concerns were based on doubt about the relevance of the initial prices to current market conditions and expected future developments in the market and also the appropriateness of applying a scaling factor in relation to a market that exhibits dynamic and uncertain growth.

The ministry’s objectives

2.5 The Ministry’s objectives for the renewal of cellular rights remain the same as for the other renewal processes. The process for renewal should:

• Generate a price that approximates the market value of the spectrum rights.
• Produce a fair financial return to the Crown for use of a scarce national resource.
• Be simple to administer.
• Be applicable in a transparent manner.

2.6 These objectives and their implications for the development of a renewal pricing methodology for cellular spectrum rights are discussed below in more detail, in reverse order (as this facilitates discussion of key issues around “market value” and “fair return”).

Objectives for the methodology

Applicable in a transparent manner

2.7 In prior renewal pricing methodologies, this objective has been interpreted as meaning that the renewal methodology and calculation should, wherever possible, use publicly available and verifiable data. We have continued to use this meaning.

2.8 We have also taken this to mean that any assumptions underpinning the methodology or its implementation should be clearly stated.

Simple to administer

2.9 This objective is taken to mean that the methodology should not be overly complex, difficult, time-consuming or costly to implement and apply in practice.

Fair financial return

2.10 The Cabinet Papers are silent on the definition of a “fair financial return” to the Crown. We would generally assume that a fair financial return is, by definition, achieved if the return is defined in the market i.e. the market value of the asset or right in question. However, this assumption rests on market value being determined in a competitive, deep market.

2.11 The wording of this objective (see above) also notes that radio spectrum is considered a scarce national resource. In the case of cellular telecommunications, while there is a finite amount of spectrum within each spectrum band, it would appear that the supply of spectrum is greater than is actually required for the efficient operation of the networks of two incumbent operators, Telecom and Vodafone, at the current levels of demand exhibited in New Zealand. Chapter 3 discusses this in greater detail.

Market value

2.12 One of the Government’s objectives for the spectrum rights reallocation process is that spectrum is to be “…reallocated based on price setting formulae that estimate the market value of the rights….” The Government has not defined the term “market value.”

2.13 “Value” is not a precise term and can have many meanings, depending on the context in which it is used. Adding “market” helps to narrow the definition, although it is still ambiguous – what is the relevant market and how is value determined in that market?

2.14 Defining “market value” is important as it guides the development and selection of a valuation approach. Whatever approach is selected must approximate a market value for spectrum rights.  

2.15 For the purposes of determining the price setting formula for renewal of spectrum rights, we have assumed that “market value” is the price at which demand and supply are brought into balance in the market (i.e. the market is cleared). The standard definition of market value is that it is: “the price that would be negotiated in an open and unrestricted market between a knowledgeable, willing but not anxious buyer, and a knowledgeable, willing but not anxious seller, both acting at arms length.”

2.16 Ideally, market value would be determined by reference to observations of the price at which the asset being valued or similar assets are traded in an active market. In the case of cellular spectrum, an active market does not exist in New Zealand, or possibly even elsewhere. Spectrum rights are not a product that is normally actively traded in the way envisaged by the market value definition.

2.17 Where value cannot be determined through observation, it is necessary to determine or calculate value using an appropriate methodology that uses market based inputs and assumptions, wherever possible, about the behaviour of buyers and sellers. The approach should derive a market price by simulating what would happen if there was an active market of buyers and sellers trading spectrum rights.

2.18 Determining an ex-ante value that will apply to a transaction, be it through observation or calculation, requires a definition of “the market”. The nature of the market will influence value. The value of an asset that is traded in an open and unrestricted market may not necessarily be the same as the value of the asset in a closed and restricted market. Typically, when applying a market value test, it would be usual to think of the market as having the following attributes:

• There are many buyers and sellers participating in the market so that there is effective competition between sellers and between buyers.
• The demand for and supply of products and services in the market are in balance or are capable of being brought into balance. There are no supply constraints that result in temporary price rises.
• There is freedom of entry and exit. Sellers and buyers do not face barriers to entering or exiting the market. Moreover, sellers and buyers are willing but not anxious participants in the market; they enter and exit the market at will.
• Buyers and sellers are equally knowledgeable about the market and the products being bought and sold in the market. There are no significant information asymmetries. In this regard the willing buyer and willing seller are “generic” – the attributes specific to the seller or the buyer are ignored and the price is indifferent to the identity of the buyer and the seller.

2.19 The market value definition does not predetermine any form of sale process that leads to the market value or price. There is an implicit assumption that the market price will be arrived at irrespective of the mechanism used to transact between the buyer and seller, so long as it does not impede the operation of the market.

2.20 In the following two sections of this report we outline the context for the renewal process and discuss how the existing right holders might view the value of the spectrum rights and the renewal process. Two key conclusions from these sections are that: 

• The actual New Zealand market within which the renewal rights will occur is different to the hypothetical market outlined above. In the particular, there is only one seller and there are only two buyers, who are incumbent operators with approximately 87% market penetration.
• The asset being valued, cellular spectrum rights, is not necessarily a scarce resource.

2.21 The implications of this are that the price the incumbent operators might be prepared to pay for spectrum might be different to the value calculated assuming a market with the attributes outlined earlier.

2.22 In one sense it might be reasonable to assume that the peculiarities of the actual market should be ignored and the value should be calculated on the basis of a deep and competitive market. It could be inferred that the reference in the Government’s objectives to market value implicitly assumes a rational, well functioning market. This will produce a robust value that should neither impede nor irrationally encourage new entrants to the market.

2.23 However, ignoring the actual market dynamics runs the risk of producing a value that might not approximate the value that would result if the spectrum rights were auctioned, which would be the actual value struck between a willing buyer and willing seller. In view of this, we consider that it is important to recognise the actual market attributes in striking the value. To do otherwise might not produce a fair financial return to the Crown.

2.24 Having regard to the discussion above, the selection of a valuation method must take into account, as appropriate, the actual market position of the buyers and the seller here and now. In particular, the likely behaviour of the buyers in response to the sale conditions as set out by the seller is important. The areas where the potential market value in a deep market might have to be adjusted reflect likely local responses to various factors causing uncertainty, which is magnified given aspects of the rights holding, given the rights’ long duration and uncertainties around factors such as:

• Demand shifts;
• Technology changes; and
• Costs of capital and operations.

Other assumptions

• 2.25 In developing the methodology, we have also assumed the following.
• The renewals process is not intended to be a regulatory exercise (i.e. to limit profits or to extract any economic rents that the current spectrum users may be enjoying).
• The Government’s overall approach to management of radio spectrum is to seek to maximise the economic and social welfare of the country as a whole. It would therefore not seek to place artificial constraints on the supply of spectrum.
• The existing rights will be renewed in their current form. The right holders will not be able to repackage any of the existing rights (e.g. combining or splitting the rights). This applies to both bandwidth and geographic coverage (i.e. the rights will remain fixed size blocks of national rights).
• The disposal method for any rights that are not renewed is likely to be an open simultaneous multiple round auction. The Ministry reserves the discretion as to whether to dispose of such rights, how to package any spectrum that is to be sold and to determine the timing of any such sale.