Following its autumn consultation on the future fees for spectrum, Ofcom has opened to consultation a proposal for how CPI should be applied in practice to calculate annual licence fees (ALFs), if it is applied as an alternative to RPI.
Ofcom had indicated that it might read across from the cost of capital applied within the mobile termination rates (MTRs), which were set relative to RPI in 2011. Setting a real cost of capital linked to RPI is an approach that Ofcom has used more generally in its decisions to date. However, the two inflation indices differ in a number of ways, and typically, although not always, RPI is larger than CPI—i.e. a higher rate of inflation is implied by RPI than by CPI. Oxera can understand why Ofcom is attracted by the merits of moving to using CPI. However, based on our assessment, we find that there are superior options available for the appropriate treatment of inflation that adequately, or better, meet Ofcom’s objectives.
In its consultation document, Ofcom states that, in the case of switching to CPI to calculate ALFs, it will use the Bank of England’s estimate of the difference between the two rates—i.e. RPI–CPI, equal to 1.3%.1 This is based on the assumption that the CPI rate of inflation will meet the Bank of England’s inflation target of 2%, implying an RPI inflation rate of 3.3% for ALF calculations. However, while we address this question in this note, it is not clear that a ‘wedge’ is required at all.
In this note we review Ofcom’s approach in the following stages.
How should CPI inflation be reflected in a discount rate? Ofcom’s approach applies a ‘wedge’ between RPI and CPI. However, such a wedge can only then be translated into a discount rate if the approach to defining the inflation wedge is consistent with Ofcom’s approach to setting the discount rate more generally.
Under Ofcom’s approach, what is a point estimate for the differential between RPI and CPI? In response to the specific question addressed by the consultation, we compare options for a point estimate and conclude that, at this stage, 1.3% is a reasonable starting point for the analysis, but is at the top of the range, and it is more probable that the actual wedge over a 20-year period will be lower than 1.3%—i.e. about 1.0–1.1%. It also appears likely that average CPI will be higher than 2%. Ofcom has not demonstrated that its approach results in an unbiased estimate for a 20-year period. An alternative approach of setting a fixed inflator of 2% should therefore be considered.
1 Ofcom (2014), ‘Annual licence fees for 900 MHz and 1800MHz: methodology to derive a discount rate consistent with CPI inflation’, Consultation, 17 April, p. 1.