Spectrum of success

After the two relatively unsuccessful attempts to sell 2G spectrum in November 2012 and March 2013, it was a case of third time lucky for the government as it hit pay dirt with the latest round of auctioning that ended on Thursday. With all the spectrum on offer in the 900 MHz band sold out and 80 per cent of that offered in the 1800 MHz band sold for a total of Rs.61,162 crore — which is substantially higher than the reserve price — the government is patting itself on the back for what it calls a big success. Yet, this has to be viewed in the backdrop of a couple of issues. First, this auction was critical for two of the biggest telecom operators in the country, Bharti Airtel and Vodafone, because their licences are set to expire later this year, and to continue in business they had to pick up spectrum irrespective of the price. So, an element of desperation was built into the bidding from the moment it began, pushing up valuations. With a new entrant in the form of Reliance Jio Infocomm queering the pitch by adding to the competitive element, it is not surprising that the final values of the 900 MHz spectrum for Delhi and Mumbai were 105 per cent and 72 per cent more than the reserve price. Of course, it could be argued that this is exactly how markets work and as the owner of the spectrum the government is entitled to get the best price.

That brings us to the second point. The auction can be truly termed as successful only when telecom services develop at affordable prices for the consumer. If the high spending by operators in the auction forces them to raise tariffs, the objective will be lost. This is exactly what happened in the 3G arena where companies outbid each other paying big bucks for spectrum, only to discover that the market was not willing to absorb the high tariffs. The net result is that 3G services have not taken off in a big way. The signals on tariff now are mixed, with the operators complaining about the money they had to cough up for the spectrum — which they are bound to anyway — but they have stopped short of saying that tariffs will rise. The competition in the market will probably ensure that tariffs do not shoot up immediately, at least for voice telephony. Groaning as they are under high debt levels, it is unlikely that telecom companies will be able to convince banks to lend more to them now; banks are under pressure from the RBI anyway as they are over-exposed to the sector. It remains to be seen how these companies manage their funds. Yet, all things considered, the bottomline is this: the auction and the money put on the table by the operators prove, yet again, the attractiveness of the telecom market in the country, notwithstanding the fact that it is already 900 million connections strong.

Why 2G auctions worked this time

After two embarrassing failures, the government is sitting pretty, now that the 2G auctions have been a success. The auctions have already netted it in excess of Rs 52,500 crore — much above the target of Rs 40,000 crore.

How did the government suddenly get its mojo back? This paper has long argued that e-auctions, with correctly set reserve fees, are the right method for allotting natural resources. More specifically, the reserve fee must be set as low as possible — just high enough to cover the basic cost of the resource, but low enough for it to attract as many bidders as possible. That's what the government managed this time. As telecom minister Kapil Sibal told this paper, "We took the bold step of rationalising reserve prices."

To be sure, DoT has lowered reserve fees after each failed round. When it started auctions for 1800 MHz spectrum in November 2012, it kept the reserve fee at an eye-popping Rs 14,000 crore for a 5 MHz pan-India block. As a result, bidding was lacklustre earning the government just Rs 9,704 crore. There were no bids in the four major circles of Delhi, Mumbai, Karnataka and Rajasthan. Worse, there were no bids received in the 800 MHz spectrum.

For the March 2013 auctions, DoT lowered the reserve fee for the four failed circles by as much as 30%. But still, bidders found the reserve fee to be too high, and there was no bidding. It was a complete disaster. In the 800 MHz band, despite a 50% lowering in reserve fees, there was only one bidder — Sistema Shyam — which picked up eight circles for Rs 3,639 crore. For the highly efficient 900 MHz spectrum — being "refarmed" for the first time — there were no bids at all. The government had egg on its face.

In the present round, DoT was forced to reduce the reserve fees further. The 1800 MHz reserve fee was lowered by a further 26% and the 900 MHz one by 50%. It's a result of these reductions that the auctions are seeing traction.

Auctions are not easy to understand, even by the brightest minds. Everyone from Trai chairman Rahul Khullar to finance minister Chidambaram to former FM Yashwant Sinha wanted to keep reserve fees too high. Maybe they were all keen to play safe after CAG's stinging indictment in the 2G scam, even though CAG never argued for a high reserve fee. Whatever the case, the lesson is there for everyone to learn. And the lesson is simple. Keep reserve fees low.

It's not the first time this lesson has been there to learn. In 2010 when 3G airwaves were first auctioned, the reserve fees were modest; Rs 700 crore per MHz, or Rs 3,500 crore for a 5 MHz block. That's what had got bidders interested. That's why the bidding continued for 34 days and 183 rounds, ending up at an astounding Rs 16,750 crore.

A mistake people make is to think that the reserve fee is what the winning bidder pays for the resource. It's not. It is merely the starting point of the bidding. If demand exists, the final bid will be higher. As a thumb rule, this paper has argued the reserve fee should be so set that the final bid is at least 30% higher. If the bidding ends at the reserve fee, or just marginally higher, it means the reserve fee was too high, and the bidding suboptimal.

A key consideration in setting the reserve fee is that all available resources should be successfully auctioned off. In the November 2012 auction, only 42% in the 1800 MHz band could be, and none at all in the 800 MHz. In March 2013, only a small part of the 800 MHz could be auctioned, and none in the 1800 and 900 MHz bands. Not auctioning everything is a scam, with the exchequer suffering real, not notional, losses.

Not being able to auction everything harms public interest as competitive intensity reduces. This leads to higher consumer prices, poor service quality and in general, a listless industry. Further, selling leftover spectrum in subsequent rounds with lower reserve fees causes problems, because winners in these rounds might have paid lesser than the ones who won in the earlier round. This would be unfair to early-round bidders. Besides all this, the government itself loses precious revenues, and interest, on the unallotted spectrum for as long as it remains unallotted.

One can only hope that the government transfers this learning experience onto the other spheres where it is about to commence auctions — coal mines, FM radio, etc.

Because the price was right

Like a good saas-bahu saga, the story of 2G spectrum allocation in India seems to have reached its end with an exciting final episode. The 2G spectrum auction has witnessed  total bids of over Rs 60,000 crore, surpassing the Rs 30,000-40,000 crore expected by the government. The auction left telecom officials relieved, particularly after the calamitous previous auctions in November 2012 and March 2013. Why has this round of auctions been successful? What lies ahead for the telecom sector?

Before answering these questions, a synopsis of the plot is in order for those casual observers who have not kept up with all the episodes in the series. It starts in early 2008, with the farcically arbitrary allocation of 122 licences (and associated spectrum) at substantially below-market rates. In 2010, following juicy plotlines involving tapped phones and corporate lobbyists, the now-famous 2G scam breaks out, with a CAG report detailing numerous irregularities in the licensing procedure. This episode also includes the arrest of then telecom minister A. Raja in early 2011. The Supreme Court annuls all 122 licences in February 2012, which leads to auctions held in November 2012 and March 2013 to allocate the spectrum afresh. Unfortunately, with the economy having taken a turn for the worse in the interim, much of the spectrum remained unsold.

The final episode involves selling this remaining spectrum, which by all accounts Trai has managed to do successfully. The main reason why the outcome of this round of auctions was different had to do with Trai getting reserve prices right. After consultation with stakeholders and considering market conditions, reserve prices were cut sharply (up to 50 per cent) compared to those in the unsuccessful previous auctions. At the time, this decision was far from universally acclaimed: many observers expressed concern over the potential loss to the government from these cuts.

One might ask: why not just increase reserve prices, and if market players do not value spectrum above these prices, they simply won’t bid? Won’t higher reserve prices lead to higher revenue for the government? The answer here is that there is no such thing as a free lunch — an increase in reserve prices may deter entrants, and in fact make it easier for remaining bidders to collude, leading to lower actual bids. To understand these ideas better, let us examine the economics behind allocating spectrum.

Radio frequency spectrum is a valuable natural resource, perhaps nowhere more so than India, where wireless telecommunication is an especially important sector of the economy. How should the government allocate this scarce resource? The allocation mechanism has two fundamental goals — to achieve allocative efficiency, that is, to ensure the most efficient use of the spectrum, and to raise revenue for the government. There is consensus amongst economists that market mechanisms — think auctions — are superior to administrative mechanisms — think Raja — in achieving these objectives.

In normal competitive auctions, there is usually no conflict between the two goals. But under conditions of natural monopoly, a small number of bidders and externalities — all characteristics of telecom markets — things get trickier. For example, the government could increase revenue collection by offering a single monopoly licence in a given region; of course, this is not good for future efficiency or consumer welfare.
Spectrum auctions are even more complicated because the underlying value of spectrum — contingent on rapidly evolving technology and changing markets — is difficult to gauge. Thus, well-understood auction problems — the winner’s curse, bidders’ risk and collusion amongst bidders — are amplified. Getting auction design right becomes paramount. Mistakes like not setting the right reserve prices can lead to disastrous consequences as in New Zealand, where bidders paid $6 for licences worth $100,000.
Fortunately, Trai got it right. Its “Recommendations on Valuation  on Reserve Price of Spectrum,” published on September 9, 2013, is a remarkable document, consisting of transparent analysis and judicious consideration of stakeholders’ concerns.
Even more commendable than simply getting the numbers right was the transparent process through which it arrived at these recommendations. It first produced a consultation paper, requesting comments from stakeholders. It then held an open discussion. All comments and documents related to the proceedings were easily available online. The data used in the analysis conducted in the recommendations report were made available, and the factors that entered the analysis clearly explained. Given the deterioration in the economy over the last 18 months, the lack of response by telecom companies in the previous auction rounds and the analysis conducted, the recommendations on reserve price cuts made sense.

The results of the current auction have justified Trai recommendations. Of course, factors other than the correct reserve prices mattered as well. For example, some telcos (Bharti Airtel, Vodafone and Idea) required spectrum in the valuable 900 MHz band just to keep existing operations going. Moreover, greater than expected demand in the Northeast, where mobile penetration is low, played a role too. But getting the fundamentals right was paramount in making sure spectrum did not remain unsold and unused.

Looking to future auctions, while Trai’s analysis in this instance was fundamentally sound, it could use more sophisticated aspects of auction theory and econometrics. For example, while the multiple regression analysis was reasonable, surely more advanced techniques could be used to calculate final numbers. In addition, the report often correctly cited the leading experts in auction theory. Why not just hire these experts to design Indian spectrum auctions in future, as the US did when it conducted its big round of spectrum auctions in  the early 1990s?

Other recommendations made in the Trai report, if adopted by the government, also stand to have a big impact on the telecom sector. Of them, the unambiguously good advice by Trai involves allowing spectrum trading. This is likely to increase efficiency in telecom markets; my previous research on the 2G scam suggested that one of the reasons the distorted allocation of licences did not affect telecom markets much was that the licences and spectrum ended up in the hands of providers likely to make efficient use of it. The suggestion to allow mergers of entities with combined market power of 50 per cent within regions is perhaps more ambiguous: while it will help with much-needed consolidation, the benefits of competition should never be underestimated. Again, my past research suggests that competitive markets may have mitigated the efficiency impact of the 2G scam.

The empowered group of ministers has already decided in favor of the M&A recommendation, while not yet reaching a decision on spectrum trading. Whatever it decides, it will do well to follow the example set forth by Trai and pursue the path of greater transparency in an effort to create the conditions and oversight necessary to let markets work.