Consultation Brief on LMCS Spectrum Auctions in Canada

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1 Consultation Brief on LMCS Spectrum Auctions in Canada by Ken Hendricks Department of Economics University of British Columbia Robert Porter Department of Economics Northwestern University January 26, 1998

2 Summary There are three main telecommunication markets: voice, data and video. The Local Multipoint Communication Systems (LMCS) spectrum to be allocated has the potential to deliver a range of broadband services in each of these three markets. The varied services include telephony, high-speed data, two-way interactive services, video conferencing, broadcast video, pay-per-view, and video on demand. Although LMCS is unlikely to replace the dominant incumbents in voice, data or video markets, it can provide a third, competitive alternative to the services currently being offered to Canadian businesses and residents. It can also stimulate the development of new, innovative services. To realize these objectives, however, a number of conditions must be satisfied. We identify four such conditions in this brief. 1. The bandwidth of the spectrum blocks has to be large enough that the license holder is not at a strategic or economic disadvantage in delivering services to the voice, data and video markets. The bandwidth necessary to achieve this requirement appears to be 1000 MHz. 2. The geographic coverage of the licenses should be large enough that the license holder can realize economies of scale in operations and marketing and not be at a strategic disadvantage vis-a-vis its rivals in the voice, data, and video markets. Because incumbent rivals have the advantage of deep penetration (in some instances, universal service) in their markets, with the attendant benefits from economies of scale, and they also enjoy national alliances for serving national accounts, the size of the LMCS licenses should also be national in scope. 3. In order to foster competition, the LMCS spectrum to be allocated should not be held by firms that already possess dominant positions in the voice, data, or video markets. Thus, telephone and cable companies should not be permitted to bid for the LMCS licenses. Further, the timing of additional entry via licensing should be designed with the goal of establishing effective competition. 4. To ensure that LMCS entrants enjoy competitive parity with incumbent LMCS operators, fees charged on licenses should not be recalibrated on the basis of auction prices, nor should incumbents be burdened by charges not imposed on competing providers. The terms of existing licenses should be changed so that they are the same as those of the new licenses. That is, they should be transferable and not subject to any greater R&D obligations or other restrictions. In this brief, we provide arguments for each of these four conditions. 2

3 A. Industry Background At present, the markets in voice, data, and video are dominated by one or two firms. Provincial telephone markets are essentially monopolies. Bell Canada has the franchise for Ontario and Quebec; each of the Maritime provinces is franchised to a subsidiary of Bell Canada; the Prairie provinces are franchised to companies that were initially government-owned but are now privatized in Alberta and Manitoba; and British Columbia is franchised to a company controlled by GTE. In dense city cores, new entrants known as competitive access providers (CAPs) have installed fiber networks that provide some competition for the telcos, but their share of the market is quite small. The long distance telephone market is more competitive with several suppliers offering service in addition to the telcos. The market for video services in English Canada is dominated by two cable companies, one of which is Rogers Cable. In Quebec, one company dominates the video market. Cable companies are monopolies in the localities where they are licensed. Cable and telephone companies are working to improve the bandwidth capabilities of their networks to deliver more services. The telcos are expanding capacity through the use of fiber and copper wire enhancements (so called XDSL). Bell Canada Enterprises has entered the video field with Direct to Home (DTH) and various telco fiber/coax trials are underway. Cable companies are deploying modems that will allow them to penetrate the data services market, while some are adding voice and other twoway services. Thus, the telcos and cable companies may soon compete more directly with each other in the data delivery market. New technologies such as DTH satellites provide a competitive alternative in the video markets. It will soon be built up to deliver channels as compared to the current channels of the cable networks, which are expanding their capacity. However, even when these developments are considered, the market for local telecommunication services in general, and local broadband services in particular, is far from being competitive. The new LMCS licenses provide the government with an opportunity to increase the number of firms offering services in the voice, video and data markets and make these markets more competitive. Recently, the government awarded LMCS licenses of 1000 Mhz to two new companies, MaxLink and WIC. (A third, Regional Vision, is licensed for smaller markets.) The two companies in the major markets each received 33 licenses in mutually exclusive areas. Unfortunately, the areas are not concentrated but scattered throughout the country. As a result, neither company can develop a national or even a provincial network, unless they join some form of alliance. This will make it more difficult for them to compete against the telcos and cable companies who have provincial licenses, deep penetration and strong national alliances; and, consequently, scale economies and marketing advantages in serving large regional and national account customers. LMCS license holders will compete head-to-head with the telcos and cable companies in providing fixed-point communication services. They cannot use their LMCS licenses to provide mobile voice (i.e., cellular) services. But the telcos and at 3

4 least one cable company can offer mobile service, which complements telephony, video and data services. The telcos have been given spectrum at the 900 Mhz and the 1900 Mhz frequency ranges to deliver cellular and PCS services in their service areas. They have formed an alliance and operate nationally through a company called Mobility Canada in order to offer subscribers national roaming privileges. The other firm in the cellular market is Rogers Cantel, which was issued a national license by the federal government. Consequently, the telcos and Rogers can offer customers the full range of communication services. If there are important synergies to be exploited in combining mobile and fixed communications services, new entrants with LMCS licenses such as MaxLink and WIC will be at a competitive disadvantage. The same may be true of the new entrants in mobile services, Microcell and Clearnet, who recently (18-24 months ago) received national PCS spectrum licenses of 30 Mhz each at the 1.9 Ghz range, although Microcell has minority cable company shareholders. B. Bandwidth Size It is our understanding that technical and economic arguments suggest that the LMCS blocks should be at least 1000 Mhz. Our ensuing discussion will assume that this is the optimal bandwidth, and that two new LMCS licenses will be allocated in each geographical area, at least one of which will be 1000 Mhz. C. Geographical Coverage Industry Canada has stated in its consultation report that its objective in auctioning LMCS licenses is to maximize consumer benefits. We believe that this objective is likely to be achieved only if Industry Canada insures a competitive environment in the delivery of voice, video and data services. An important issue that needs to be addressed in this regard is the geographical coverage of the new licenses, particularly in comparison to those recently issued to MaxLink and WIC. The tradition in the telecommunications industry has been provincial or national licenses. As cable enters this field, regional clustering of cable companies has been facilitated. This suggests that the LMCS licenses should be either provincial or national as well. But the current MaxLink and WIC LMCS holdings are not contiguous. Instead, they comprise an odd patchwork of local areas. This raises two difficulties. First, efficiency requires regional clustering. Dividing the licenses in a region between two firms may mean that neither firm has enough customers to justify the fixed costs of installing a network in some markets. In any event, the division means each license holder has an inefficient situation in facilities, operations, and marketing. As a result, some local areas may not be competitively serviced even though the region has a sufficiently large population to support a network. Second, MaxLink and WIC cannot realize the economies of scale in facilities, operations and marketing available to their rivals. They are not in a position to serve regional and national customers, who constitute a significant market segment. This places them at a cost and marketing disadvantage visa-vis the telcos and cable companies. The next entrants may also be at a disadvantage, depending upon the size of the new LMCS licenses. 4

5 One possible strategy that the government could pursue is to design the geographic coverage of the next LMCS licenses so that MaxLink and WIC are able to acquire, via the auction, the local licenses needed to fill in gaps in national or regional aggregations. This strategy has a number of disadvantages. The LMCS licenses are likely to be too small, thereby reducing the value of the licenses to new entrants. It places new entrants at a strategic disadvantage in bidding against MaxLink and WIC. Finally, MaxLink and WIC may not win the licenses that they need for efficient agglomeration of licenses. Indeed, they are unlikely to win if the telcos and cable companies are permitted to bid. A second possible strategy is to correct the current situation by ensuring that MaxLink and WIC swap current licenses to achieve at least regionally efficient patterns of license holdings. This would give the government the freedom to choose whatever geographic license areas it believes is likely to be most efficient without regard to the holdings of incumbent LMCS license holders. It could deny MaxLink and WIC the economies and marketing opportunities of national coverage, however, unless they attain national license holdings. Unfortunately, a negotiated swap may be difficult to arrange given the different ways in which the two companies intend to use their LMCS licenses and the particular markets awarded to them. A third strategy available to the government is to divide a new national license between MaxLink and WIC so that each company has a national network. This would lead to efficiency in the supply of services, since it guarantees competition at the right geographical coverage. The remaining LMCS licenses could be regional or national and awarded by auction with everyone allowed to bid, subject to the eligibility restrictions described below. This strategy would be consistent with previous allocations in which the government awarded a national cellular license to Cantel and national PCS licenses to Clearnet and Microcell, while the telcos received provincial licenses. There would then be as many as four, and possibly five (depending upon who wins the remaining license), potential suppliers of broadband services with a competitive national presence. There would also be other niche or regional competitors where economically justified. This strategic option ensures an economically efficient result. There is a further argument in favor of national LMCS markets. If the LMCS licenses are small and all held by new entrants, they are likely to achieve small penetration in local markets against incumbent providers. A national license would permit the entrants to achieve economies of scale in marketing and in new service development. In addition, although the telcos and cable companies do not have national licenses, the incumbents participate in long established national alliances. The independent cellular and PCS entrants have national licenses as well. D. Eligibility The other issue that needs to be addressed is which companies are eligible to bid for LMCS licenses. Should the telcos and cable companies be permitted to bid? What 5

6 about cellular firms like Clearnet and Microcell? Should the interexchange carriers in long distance be allowed to participate? The U.S. Federal Communications Commission (FCC) adopted an eligibility restriction rule, under which firms were not allowed to bid for PCS licenses in areas where they had cellular licenses. As a consequence, some firms sold their cellular holdings in order to gain eligibility. The FCC also excluded all inmarket incumbents from the auctions for LMCS service. Applying this principle to LMCS licenses in Canada would imply that the telcos and cable companies would not be allowed to bid for licenses in areas where they currently operate. We present four factors that the government needs to consider in developing its eligibility restrictions. In each case, there is a conflict between the efficiency of the auction outcome and the revenue raising potential of the auction. The Industry Canada consultation report indicates, however, that efficiency is the primary goal. First, in calculating the value of the LMCS license, dominant incumbents will take into account the loss of profits on their existing services that would occur if the license were won by a new entrant. This is the classic argument developed by Richard Gilbert and David Newbery (American Economic Review, 1982) to explain the persistence of monopolies. An incumbent monopolist or dominant firm is willing to pay more to extend its operations into a new service than a potential entrant is willing to pay to establish a competing service, because some of the gains from competition accrue to consumers. Second, additional suppliers are likely to improve efficiency in a highly differentiated industry like that of broadband services, where concentration of market power affects the range of products offered as well as the prices at which they are offered. A monopolist tends to offer fewer products because, in deciding whether to offer a new product, it takes into account the loss of revenues on its existing, substitute offerings. For example, if a telephone company is awarded one of the new LMCS licenses, it is more likely to use it to deliver broadband data services, since it is already servicing the voice market using its wire network. A cable company, on the other hand, will want to use the LMCS license to penetrate the voice or data markets, since it is already servicing the video market with cable. Each company will attempt to use the license to augment the range of services it is currently providing and not to offer competing services. By contrast, a new entrant like MaxLink will use the license to deliver services in voice, data, and video services, competing with the telcos and cable companies in each of their markets. New entrants may also be more likely to innovate, in their effort to attain a competitive foothold in the market. Third, a new entrant will have to incur a large fixed cost in establishing a network. An incumbent firm has already sunk costs in establishing its network, and to the extent that this network can be used to deliver LMCS-based services, it can deter entry. An incumbent firm would have to incur costs in developing LMCS hookups, but they will have already incurred many of the costs associated with transmission between locations, such as switches, network wiring and other network elements, operating systems and controls. Competition will result in prices that allow incumbent providers to 6

7 recover operating costs, but a new entrant may not be able to recover its additional fixed costs. An offsetting consideration is that there may be economies of scope in providing LMCS-based services jointly with other services, in which case it would be efficient for an existing supplier to acquire an LMCS license and thereby avoid the duplication of fixed costs. It is an empirical issue whether the monopolization effect is more important than the cost saving effect. The efficiency stimulus of competition will exceed any infrastructure cost savings of monopoly or dominance if demand is sufficiently elastic. For example, concerns that there would be overbuilding of fiber capacity for competitive long distance service have proven unwarranted, and extra capacity has been added to accommodate the increase in demand from lower prices and enhanced service. The combined strength of the above three arguments strongly suggests that telcos and cable companies should be prohibited from bidding for licenses in areas where they are currently licensed. But that still leaves the question of whether the telcos and cable companies should be allowed to bid for licenses in areas where they are currently not operating. The main objection to allowing telcos to bid for LMCS licenses in areas where they are currently not licensed is that they operate jointly via Stentor in the fixed market and through Mobility Canada in servicing the complementary market of mobile voice. Given this situation, it is unlikely that the telcos will compete vigorously against each other in offering fixed communication services. It is more likely that they will extend their cooperation in long distance, end-to-end local and mobile markets and services to telephony, video and data markets served by LMCS, in which they may offer services that are potential substitutes. Cooperation may be reflected in noncompetitive pricing; a more subtle form of cooperation lies in providing services that are maximally differentiated. The other factor that argues for making the telcos and cable companies ineligible to bid for any LMCS licenses is that they currently offer complementary services, such as telephony and mobile voice. These companies then have the opportunity to tie the provision of LMCS services with their existing services, and so leverage market power in one market into LMCS markets. This is especially a concern if the existing service is an essential facility, in which case consumers need to have access to the existing services. These arguments have figured prominently in the US Justice Department moves to block Microsoft expansion into related software markets, such as the decision to block the Microsoft acquisition of Intuit, or the recent attempt to uncouple Internet Explorer from Windows 95. An offsetting consideration is that there may be economies of scope or consumer benefits in providing LMCS services jointly with other services. Once again, it is an empirical issue whether the monopolization effect is more important than the synergy effect. As described above, the monopolization effect is most detrimental when demand is elastic, and monopoly pricing leads to significant distortions. Note that this issue of pricing complementary goods is also relevant for the question of whether Clearnet and Microcell should be permitted to bid. 7

8 With respect to interexchange carriers, it is unlikely that there will enough spectrum allocated to provide each carrier with their own local access spectrum. To provide some with such capacity, to the exclusion of others, would distort competition among interexchange carriers. Further, there is a concern that interexchange carriers could tie their services to LMCS service, placing independent LMCS licensees at a competitive disadvantage. Interexchange carriers will have the opportunity to negotiate with providers of local service in any event, so they can offer a competitive package of services, just as LMCS licensees can negotiate arrangements with long distance suppliers. E. License Terms Incumbents and entrants should compete on a level playing field, with neither enjoying a strategic or economic advantage due to the terms of the licenses. It is important that the new LMCS licensees not face a greater public fee burden than that of incumbent providers. The recalibration of license fees, which would tie license fees for existing LMCS licenses to the bids for the licenses that are to be allocated by auction, poses several problems. First, there is a concern if existing LMCS license fees are to be recalibrated based on the auction outcomes, and if firms with dominant positions in competing services (such as voice, data and video) are eligible to bid. In that case, the dominant firms from competing markets have an incentive to bid up LMCS prices to drive up the costs of providing rival LMCS service. Second, recalibration would be a difficult exercise in any event, because the existing LMCS licenses are not directly comparable to the new LMCS licenses that are to be sold. The existing licenses have R&D requirements, the license holders have industrial benefit commitments, and the licenses are not freely transferable. Third, to promote consumer efficiency, it is important that the various service providers compete on a level playing field. This includes not only existing and prospective LMCS licensees, but also incumbent telcos and cable companies. Recalibration of existing LMCS licenses, without also recalibrating telco and cable franchises (or initiating a comparable fee for those providers currently paying no fee), will reduce competition by harming the competitive position of LMCS providers. Fourth, a portion of the auction prices may reflect cost savings or service benefits from new wireless technology, in comparison with less efficient existing technologies. The new technology will be available to all potential bidders, and hence some of the relative savings will be capitalized in the bids submitted, to the point that competition among new service providers may be limited. The less efficient technology will be sheltered from competition, in that LMCS providers will incur additional costs associated with the higher bids. We also believe that the proposed payment structure, in which bids can be paid on an installment basis, is likely to lead to inefficiencies. First, any financial gains from the 8

9 option of making installment payments are likely to be capitalized into bid prices. That is, bids will be higher as a consequence. To the extent that some of the bid must be paid up front, this will offset the purpose of the installment option, to lower barriers to entry. Second, inefficient firms will be more likely to win the auction. An installment plan is like an option. If the investment in LMCS turns out to be profitable after the fact, then the bidders will willingly make their payments. If LMCS turns out to be unprofitable, then it will be rational to default on the payments. In this sense, bidders on an installment plan are protected from downside risk. There is then a distortion in bidding incentives, as bidders who intend to use the spectrum for relatively risky purposes gain a relative advantage. Installment payment plans also encourage speculative bidding, as there is less incentive to gather and analyze information prior to the auction. Arguably, the experience in the US FCC C block PCS auctions indicates that these are not hypothetical concerns. Many bidders on the installment payment plan for the C block decided to default, in part because they lowered their expectations about the profitability of their licenses after the auction. They learned more about the costs and capabilities of the technology, and they learned that the FCC was aggressively going to sell more spectrum. Third, there will be a distortion of ex post investment decisions. As noted above, an installment plan is like an option that insures against downside risk, and as such it encourages relatively risky investment decisions after the auction. F. Clarification of Futures Sales and Spectrum Management Before the auction is held, Industry Canada should specify, as precisely as possible, their intentions concerning future regulation of LMCS and related services, as well as any plans for future spectrum sales. This information is necessary for potential bidders in the process of forming strategic plans. It is also vital that Industry Canada indicate clearly how the eligibility restrictions on bidding extend to the resale market. That is, if telcos and cable companies are barred from bidding for LMCS licenses, then they should also be barred from purchasing the licenses from the winning bidders. This does not preclude their use of the platform by leasing access to capacity from independent competitive licensees. Finally, given the prospective competition in local telecommunications from telcos, cablecos, CAPs, LMCS and other wireless facilities, there may be a benefit to delaying any additional new LMCS entrants for a period of time. A delay would allow the current new entrants to obtain financing and establish their services nationally. This argument is analogous to that in favour of protecting an infant industry, where early entrants are sheltered from competition for a short period to gain a market toehold. A similar argument is made to justify granting patents, which shelter early entrants from competition so that the benefits from innovation can accrue initially to the innovating firm. 9

10 G. Conclusions Industry Canada has stated in its consultation report that its objective in auctioning LMCS licenses is to maximize consumer benefits. We believe that this objective is likely to be achieved only if Industry Canada insures a competitive environment in the delivery of voice, video and data services, and if the distribution of licenses promotes market efficiency. To realize these objectives, several conditions must be satisfied. 1. The objectives are best served by national LMCS licenses with 1000 Mhz of bandwidth. This result can be ensured only by direct government action to allocate licenses accordingly. 2. In order to foster competition, the LMCS spectrum to be allocated should not be held by firms that already possess dominant positions in the voice, data, or video markets. Thus, telephone and cable companies should not be permitted to bid for the LMCS licenses. The auction outcome may be more efficient if the mobile licensees and interexchange carriers are also not eligible to bid. 3. All local telecommunication service providers should be treated equally with respect to public fees for conducting their businesses. New wireless entrants should not be subject to fees not also imposed on incumbent providers of substitute services. Their fees should not be recalibrated by virtue of later bid prices. Nor should they be subject to different rights or obligations than those of other existing and future licensees. 4. The regulatory rules and future letting of spectrum should be known and fixed before spectrum is allocated to new licenses via auction. Further, the timing of additional entry via licensing should be designed with the goal of establishing effective competition. 5. A payment plan in which bids can be paid on an installment basis is likely to lead to inefficiencies. 10