Why The White House and CTIA Don’t Agree On Incentive Auction Revenue, And Why I Think Both May Be Wrong.

The White House budget proposed last week contains an estimate of about $28 billion from auctioning federal spectrum and giving the FCC authority to conduct incentive auctions.  By contrast, the CTIA – The Wireless industry Association — and the Consumer Electronic Association (CEA) have published a study showing that the FCC could raise $33 bn from an incentive auction of the broadcast bands alone. So what gives?

The short answer is that spectrum auctions are extremely hard to predict, and incentive auctions are even harder to predict because we’ve never done one before. The longer answer is that because the White House is banking on the revenue as part of the budget process with real world consequences, they have therefore hedged against uncertainty by including an easier to estimate spectrum auction. CTIA/CEA, have written an advocacy piece. As with all such pieces, it tends to accent the positive. Unfortunately, the Report fails to address some rather pivotal issues, a factor that renders it of rather limited utility for resolving what I consider the most critical question no one has answered: will enough broadcasters participate in a voluntary auction to make it happen at all. It is on this point in particular that I remain profoundly skeptical.

Fair warning, as with all spectrum policy posts, this one tends to run pretty long. Still, I’m hoping the prospect of all that money  will rivet folks as I unpack the “known unknowns,” the “unknown unknowns,” and why I raise a skeptical eyebrow over the CTIA/CEA estimate below .  .  .  .

UPDATE: As I’ve explained here, I’ve edited this article considerably to take out some unwarranted snark on my part against CTIA/CEA.

Some Background

Lets start with the dirty secret of estimating revenue from spectrum auctions. No one can predict with any degree of certainty what spectrum auctions will fetch. If that sounds strange, consider how valuations can change for a house. A county assessor comes away with a guess based on factors like the general value in the neighborhood of similar houses. If you refinance, an appraiser will come by and make another assessment, considering what they can see from a quick evaluation and based on what other houses she considers similar. Put the house on the market 6 months later and you may get an entirely different amount (assuming I can sell at all), either higher or lower, depending on such factors as what interest rates are doing and how many people are looking to buy a home this month.

Appraising houses is routine, but we still have wild variances. Spectrum auctions are rare beasties with years intervening between auctions. Lots of factors, from the state of financial markets to the nature of the spectrum to whether potential bidders expect other spectrum to come on the market anytime soon or whether this is the one chance they have to get what they need.

To this uncertainty, we add the whole new concept of “incentive auctions.” For those just tuning in, “incentive auctions” refers to letting existing licensees get a piece of the auction revenue in exchange for putting their licenses up for auction.  The National Broadband Plan proposed that Congress give the FCC the authority to conduct incentive auctions, with a goal of getting broadcasters to give up 120 MHz of broadcast spectrum voluntarily. Everybody focuses on the broadcast bands because that is the best spectrum for wireless broadband and will fetch the most at auction.

The trick is that as a sop to the political power of broadcasters, the FCC recommended that participation in incentive auctions should be voluntary. Nobody has to participate. It’s just an option for those broadcasters that want it. But this tends to gloss over some unpleasant realities for the broadcasters that do not want to participate. Wireless companies are not interested in buying random broadcast licenses. To plug this spectrum into their existing networks, and make it worth bidding on in a big revenue spectrum auction like we had for the returned television spectrum after the conversion to DTV, we need to reshuffle things so that entire channels (preferably the top UHF channels) are clear for auctioning on a national basis.

Clearing these bands requires a process called “repacking.” Anyone still operating on the bands being cleared has to move to one of the remaining broadcast bands. Because some of the markets are crowded , this means that some of the broadcasters on remaining bands may also have to move to a new band. The moving process – which may involve physically moving towers and transmitters or replacing equipment – can cost the remaining stations some serious change. Obviously, in addition to broadcasters wanting to make sure that participation in incentive auctions remains entirely voluntary (as opposed to “voluntary”), broadcasters also want to make sure that those who remain behind don’t get stuck with the repacking cost. Finally, as we discovered when we did the white spaces proceeding, a lot of other people live in the “broadcast bands” on a secondary basis. These licensees (low-power TV, wireless microphones, cable head ends) are all going to want to get compensated for needing to move again – assuming there is even space left over for these guys to survive.

Known Unknowns, Unknown Unknowns

So any effort to estimate auction revenue has to take into account a bunch of unknowns about the future. But at least folks have an understanding of the relevant factors. For incentive auctions, we have a whole bunch of new “known unknowns” that impact revenue.

How many broadcasters will participate? This is actually the biggest question. Even more important, which broadcasters will participate. Because of the mechanics of repacking, you cannot get cleared bands without some critical mass of broadcasters from the largest, most populous, and most crowded markets. In most of the country, we have lots of unassigned television channels and we can clear the bands fairly easily. But get to New York or Chicago or Los Angeles and it becomes impossible to clear bands for auction unless a bunch of broadcasters decide to participate and go out of business. The problem, of course, is that these are the most profitable stations, and therefore the ones least likely to sell out.

How big is the payout to broadcasters? Remember, the broadcasters don’t particularly want to sell. That’s where the “incentive” part of “incentive auction” comes in. The idea is to bribe them to sell the spectrum (which they got from the public for free, but lets pass over that for the moment). The larger the bribe to broadcasters, the less money remains for the federal government after an auction.

What are the repacking costs? If we’re serious about the “totally voluntary” stuff, that means covering the cost of repacking.  While it is possible to make estimates based on how much it cost to repack after the transition to digital television in 2008, there are enough elements in this formula that remain unclear that I still classify it as unknown.

What about everyone else in the band? Finally, what about all the secondary services, or the unlicensed white space users? Do these guys get some kind of handout? Do we set aside spectrum for their use? Or do we just say “sucks to be you?”

As for unknown unknowns, well – that’s always the fun part. All I can say is that long experience with spectrum and efforts to totally rework existing services never go as planned. Any effort to try to guess auction revenue ought to at least make a nod in the direction of the fact that there may be other expenses that arise before the federal government can book the revenue.

So How Do The White House and CTIA/CEA Deal With These Problems?

Both the White House and CTIA/CEA claim to make “conservative” estimates. While it’s harder to judge the White House because they have not released the underlying basis for their estimate of $28 billion, I think they actually do a better job (and have the more believable estimate) than CTIA/CEA because of the way they hedge against the risks in the unknowns.

The White House appears to have hedged against the unknowns in incentive auctions (and spectrum auctions generally) by including a nice chunk of federal spectrum in the auction bundle. The White House designated 115 MHz of fed spectrum for clearing an auctioning, including a chunk very similar to the AWS-1 Auction which went for $14 bn in 2006.

Granted, it’s not clear the White House can actually get this spectrum clear. Nor is it clear that it will sell at comparable prices. Lord knows I would have trouble selling my house today at the valuation I could have gotten in 2006 for reasons having nothing whatsoever to do with my house.  But it does mean that the White House is being cautious in how it treats the even-harder-to-predict unknowns in an incentive auction. By hedging the risk of incentive auctions with the somewhat less risky federal spectrum, the White House budget certainly passes the “laugh test” as at least plausible. But without further details on how they made their revenue estimates, I can’t really say if I think they are unduly optimistic, sensible, or genuinely conservative.

Bottom line, I treat the White House estimate rather like your investment adviser for your 401(k) (if you have one). You are playing the percentages, but nothing guarantees that a particular fund is going to perform well or poorly.

Why I’m Much More Skeptical of CTIA/CEA’s Estimate

On the other hand, I’m a heck of a lot more skeptical about the CTIA/CEA estimate of $33 bn for incentive auctions alone. You can download the study here. Bluntly, the Report fails to address with any clarity the most critical question: what level of broadcaster participation, particularly in the top markets, do you predict? They then compound this problem with what I consider an unrealisticly low estimate of broadcaster payout. CTIA/CEA acknowledge these issues obliquely and in a few footnotes, but such asides cannot, in my opinion, justify the $33 bn headline. At best, $33 bn is an ideal case assuming everything works out, not a “conservative estimate” of how things are actually likely to play out in the kind of voluntary incentive auctions Congress and the FCC keep talking about authorizing.

CTIA/CEA start with the assumption that the FCC can find the 120 MHz of broadcast spectrum recommended in the national broadband plan, and projects revenue accordingly. That already makes this a “best case” scenario because — judging from the comments from broadcasters so far — nothing indicates that we will actually get to that level of participation. When CTIA/CEA say the Report estimates are “conservative,” they mean that they have tried to reflect changes in the market since the last broadcast spectrum auction and not just assume you could get the same high valuations as last time. That’s fine as far as it goes. But if you want to assume that the FCC will get the full 120 MHz, you need to state with clarity how many full power broadcasters, and in what markets, need to participate to make these assumptions true. Because without that critical information, there is no way to evaluate how likely it is that the FCC will get the 120 MHz that form the basis of the estimate — or how many broadcasters you will need to bribe to participate and how large that bribe will need to be. It is going to take a heck of a lot more money to bribe four full power broadcasters in New York or Sand Diego, for example, than four full power broadcasters in Detroit and Des Moines.

Unfortunately — and this is where my skepticism starts kicking in big time — no where does a specific number of stations needed to participate appear anywhere in the Report. Instead, the Report elides around it. On page 13, the Report states: “in all but a few Top-30 markets, very few stations must voluntarily exit or adopt a non-exit alternative to free a channel.” To translate into more skeptical language: in the top 30 markets, to make this work, some undisclosed number of broadcasters are going to have to get out of the broadcasting business. The Report suggests this might be facilitated by using ‘non-exit alternatives,’ which is polite language for somewhat more coercive strategies of forcing existing broadcasters to share spectrum or reduce license size so we can squeeze more broadcasters into the remaining space or otherwise encouraging them to “exit.” While that is certainly consistent with past recommendations of CTIA and CEA to the FCC, it is not on the table in any of the current proposals (which continue to stress how ‘voluntary’ this will be), so I consider it about as likely to happen as my usual push for spectrum caps.

This rather unfortunate omission is then compounded by another caveat which pushes my skepticism of the $33 bn into the red. The Report projects an absurdly low pay out to broadcasters. Apparently acknowledging this, the Report cautions: “these approaches are used to derive a station’s market value, not a station’s exit price in an incentive auction.  Depending upon expectations that may be created by the regulatory process or perceptions of risk, stations may not be willing to exit at their projected market value and may hold out for some amount above that value.” (Emphasis in original)

To translate: “This is what we think the stations are actually worth, not what you would actually have to pay them to get them to stop being broadcasters and sell their licenses.” That would be fine if we were planning to take away the licenses and compensate the broadcasters for fair market value. But the whole point of the “incentive auction” is to create “incentive” and bribe broadcasters to give up licenses voluntarily. To get people to sell voluntarily when they do not want to sell, you have to offer them more than fair market value, usually a lot more. For example, lets pretend my house is appraised at $X. An economist would say I should rationally sell at a price of $X+1. But anybody who lives in the real world knows that, if I have no interest in moving, I am very unlikely to sell for $X+1, even if $X+1 is a good offer.

That’s rather a problem because broadcasters are as attached to their spectrum as the grumpy old guy in Up! was attached to his house. To get broadcasters to voluntarily sell out, you are going to need to pay not only the “fair market value” of $X, but the “exit price” of $X+$Y. As the Report grudgingly concedes, the value for $Y in a voluntary auction is likely to be “much larger.”

Finally, as for what happens to all the secondary services, the Report mentions in passing that they are toast. While I give them credit for being up front about this, I flag it as politically problematic and therefore tack it on to my list of reasons to be skeptical about the $33 bn number. Nor am I alone. BIA-Kelsey likewise has criticized the report for being “overly optimistic,” particularly with regard to its conclusion that LPTV will simply disappear.

My bottom line on the CTIA/CEA Report is that it’s not a bad estimate for an involuntary auction where we pay to migrate broadcasters (as the Commission has done in the past when it has cleared out one set of licensees to make room for another). That was, of course, CTIA’s original policy recommendation when the FCC first raised the issue back in late 2009. But that is clearly not going to happen. As an estimate for what a voluntary incentive auction will take in, I don’t think it provides a terribly realistic projection of how things are likely to play out.

Are Incentive Auctions Worth Doing At All?

All of which leaves unanswered the question of whether we would have enough participation in the major markets to make incentive auctions happen at all. My own back-of-the-envelop calculation is that you need at least three full power broadcasters willing to “exit” in each of the top 10 markets to make incentive auctions worth doing. Nothing anyone has said so far makes me think that’s likely to happen unless we spend big bucks to bribe them or unless we are willing to force them. Unfortunately, neither the White House nor CTIA/CEA have really addressed this question. Both estimates assume we will get the minimum level of participation to make this worth doing.

When the FCC proposed incentive auctions, it justified it in part on the argument of “give us the authority because it gives us one more tool that could end up being really useful.” Under that argument, it doesn’t matter whether you think enough broadcasters will participate. You give the FCC authority and if enough broadcasters show up, you have an auction. Otherwise, you don’t. The problem with the current budget process is that we are now saying “give the FCC this authority because we are banking on that revenue to fund all kinds of good stuff.” When you shift to that line of reasoning, then you absolutely need to determine the threshold question of whether we will get enough participation to have incentive auctions at all. Because by the time we get incentive auctions set up, we will have spent the money we project will come out of the auctions. That argues for a healthy dose of pessimism in our estimates, lest we end up further in the deficit hole.

As an aside, I expect this is one reason why broadcasters are surprising some folks with their resistance to the whole idea of incentive auctions. They understand that if Congress expects billions of dollars from an incentive auction in 2013 and doesn’t get it, then Congress is likely to push broadcasters harder to participate. Or, as I have said before, incentive auctions are likely to go from voluntary to “voluntary” if the revenue projections from truly voluntary fall way short. After all, that’s what happened in 2005 when we set a hard date for the DTV transition. We started in the 1996 Act with something voluntary and industry driven. Then, as the bills for the Iraq War mounted and we needed the revenue, Congress got tired of waiting and simply ordered broadcasters to convert to digital so we could auction the spectrum in 2008. Broadcasters would really like to make sure that doesn’t happen again.

We Need to Fess Up And Make Decisions Based On What We Know And Know We Don’t Know.

As I recently noted on USF, we ought to make policy decisions on the basis of what we know and what trade offs we’re honestly willing to make. Yes, a lot of times that means making decisions based on best guesses. Doing nothing until we have absolute certainty is a recipe for disaster, because absolute certainty never exists about anything. Especially when it comes to hard questions like spectrum policy, we need to live with the fact that the data is often ambiguous and difficult to interpret and that there are several possible outcomes depending on what we want to accomplish as a matter of policy.

So I’m not saying that we need absolute certainty on how much an incentive auction would bring in before Congress should authorize one. As I pointed out above, we will never know with certainty what revenues spectrum auctions will produce. But we still need to hedge against risk and act on realistic assumptions about how the world will actually work once legislation is passed.   From what I can tell so far, I think the White House has at least tried to come up with a way to cover the projected costs and create revenue, although I would feel a heck of a lot better if I could see their underlying assumptions. CTIA/CEA, in my opinion, have not adequately hedged against the risks for incentive auctions. I’m still not sold on the White House’s estimate of $28 bn. But I find it much more likely than $33 bn from incentive auctions alone.

Stay tuned . . . .