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What is the right discount rate for an ALF?

In its consultation, Ofcom is proposing to change how licence owners of 900Mhz and 1800 Mhz spectrum pay for their annual licence fee (ALF). The consequence of its proposals is a significant increase in the value of the payments for the use of that spectrum. Ofcom proposes that the ALF be calculated as follows:

  • estimate a single lump-sum payment that would have been realised if this spectrum had been sold in that way, based on evidence from recent auctions for 4G and other spectrum;

  • 'annuitise’ the value of the lump sum into an equivalent annual payment, to be increased each year at RPI. To achieve this equivalence, Ofcom proposes to apply the post-tax real weighted average cost of capital (WACC) of an efficient mobile network operator (MNO) as the discount rate to these annual payments, such that their net present value is equal to the single lump sum calculated in the first step.

In paragraph 5.21 of its consultation, Ofcom states that the ALF should make the licence holder ‘indifferent between paying the annual fee and paying the lump-sum value’.

Having reviewed Ofcom’s analysis, we find that, within the regulatory framework applied by Ofcom, the second part of this calculation is not consistent with how the equivalent ALF should be calculated. In particular, we find that:

  • the proposed ALF is more in the nature of a debt obligation, or, specifically, a lease-type obligation;

  • as a result, the methodology for converting such an obligation into a lump sum would be consistent with that applied in valuing debt or lease obligations—i.e. at a rate comparable to the cost of debt;

  • in practice, for any notional MNO with the ability to raise debt finance, it will not be indifferent if the WACC were to be used as the discount rate. The MNO would become indifferent only if the discount rate used were consistent with an appropriate measure of the cost of debt;

  • the impact is material. Ofcom’s proposed level would reduce the average licence fee paid by £20m.