There Is No Such Thing As A Free Lunch!
Only the most naïve or uninformed consumer will take issue with this familiar adage. Wary consumers know that in the end, they always pay — directly or indirectly, sooner or later, one way or another — but always!
Notwithstanding, some at the Federal Communications Commission (FCC) would have consumers believe that there is such a thing as “free” Internet service. In defense of his plan to sell valuable spectrum on the condition that the winning bidder commit to offer free wireless broadband, Chairman Kevin Martin recently told the House Energy and Commerce Telecommunications Subcommittee: “…if someone is willing to make that kind of a commitment…that’s a significant public interest benefit.”
Neither the Chairman nor the other FCC Commissioners who have publicly expressed support for the plan have mentioned “cost.” This ConsumerGram raises some unanswered questions about the costs associated with the plan and explains why the embattled American consumer will be forced to pay them.
On May 23, 2008 FCC Chairman Kevin Martin announced a plan to reassign and combine spectrum blocks so as to create a contiguous 25 MHz block (the Advanced Wireless III or AWS III band) for auction only to bidders who agree to dedicate “up to” 25% of system capacity for free wireless broadband. That’s right: free wireless broadband; no charge; a gift from the government and the winning bidder.
The plan would require the winning bidder to offer service to 50% and 95% of the population of the United States within four and fifteen years respectively. By some estimates capital expenditures for construction of such a system would be on the order of $20 billion, while operating expenses would amount to $2 billion or so annually. Spectrum costs from the auction would be added to that. All these costs would have to be recovered from 75% of the subscriber base in what is sure to be a very competitive marketplace.
The plan has only been sketched out and important details remain to be determined. Nevertheless, informed consumers and taxpayers know enough about deals offering “something for nothing” to ask for answers to some pretty straightforward questions.
Question 1. What are consumers getting for free?
Consumers are entitled to know what they are getting and what they are giving up. In numerous other market contexts government requires full disclosure by private parties of the terms and conditions of offers by firms of good and services. The promise of free wireless broadband is quite seductive, and consumers are frequently bombarded with mailings and media ads promising free goods or services; however, there is invariably some catch, some hidden provision or some unpublicized condition that gives the lie to promises of something for nothing. But, most American consumers have learned that the devil is in the details.
American consumers have learned to check out the fine print but with this “free wireless broadband” plan, there is no fine print to review. So, what are consumers going to get in return for the spectrum set aside? Truth is: nobody knows! At this point, we do not know precisely the amount of capacity to be dedicated to free service (“up to 25%”); nor its cost in terms of reduced auction proceeds from the severe business plan restrictions; nor the overall quality, speed, availability, and functionality of the service. Nor is it clear how demand for the “free’ service will be rationed. Excess demand will materialize if the value of the service at the margin is greater than its zero price. And, most notably, the FCC in its recent Further Notice of Proposed Rulemaking on the rules governing AWS III, neither solicited public views on these matters, nor gave consumers a hint of what it has in mind. Finally, nowhere in any of the materials is there a discussion of who pays for the mobile devices that consumers will need in order to access the service. Will these devices be free, like the service or will this be another hidden cost for consumers?
This is not acceptable. Citizens are entitled to know exactly what they are getting in exchange for the reduced revenue that the federal government will collect from auctioning this scarce spectrum – revenue that would have been used to fund government federal programs and offset consumer taxes.
Question 2. What will the free wireless broadband service plan cost consumers?
Most consumers have learned well an important life and economics lesson: TINSTAAFL! There is no such thing as a free lunch.
So, who pays for free wireless broadband under this plan? In short, the U.S. taxpayer. Do not look to the financial backers of the plan. They have no intention to underwrite free services. To the contrary, most serious investors require higher returns to cover a risk premium on their investments, and to reflect the uncertainty of a business plan built around giving away the output from 25% of their risk capital. Serious bidders for the spectrum in question will recognize that revenue streams generated by advertisers and/or the service’s paying subscribers may very well not produce enough revenue to offset the absence of revenue from 25% of the service’s subscribers. Serious bidders for the spectrum will reflect this higher risk profile in their bids. The result will tend to close the auction to risk-averse investors and to invite speculation.
Since American taxpayers will bear much of the cost and risk, they might reasonably ask for some quantification of the risk and cost they are being asked to shoulder. Regrettably, there is not much in the record to give consumers a clue as to their ultimate exposure. The plan mirrors many of the features of a proposal floated last year by M2Z Networks, backed by several well-known venture capital firms including Kleiner Perkins and Charles River Venters. We looked at the original M2Z proposal, in vain, for hints of the cost of the free wireless broadband service. The M2Z proposal treats the service as free and makes no mention of the reduced value of spectrum proceeds, nor does it consider the opportunity cost of services foregone by other potential uses of the spectrum and the risks to taxpayers and consumers of what by any reasonable estimate is an enormously risky business plan. In support of its proposal, M2Z Networks offered “cost-benefit” studies that grossly exaggerated the potential benefits of the proposal, while ignoring the associated costs, including most notably, the value foregone by taxpayers from an open auction that does not cater to a particular technology and business plan. It turns out that the promised “free lunch” is neither free nor very nourishing.
Question 3. What is the likelihood of success of a business plan built around giving service away for no charge?
Since consumer advocates and other stakeholders do not know important details of the plan, it is difficult to analyze its implications. Nevertheless, even without details, several conclusions can be confidently drawn.
First, there have been several previous attempts to provide “free” Internet services and we cannot identify any notable successes. Failures are the rule for both private sector efforts and numerous municipal attempts to build Wi-Fi systems. Space does not allow even minimal description of other FCC failures to gerrymander a specific technical and/or business outcome, or the fate of numerous similar, well-intended efforts of municipalities attempting to finesse market realities by offering low cost or free wireless broadband services. But, as Casey Stengel famously observed: “You can look it up!”
Secondly, market realities dictate the implausibility of success of a business case built on giving service away. To illustrate, suppose the set aside for “free” service is 25% of the network’s capability. What are the implications of getting no revenue, no earnings, and no contribution to cost from 25% of the users, assets, plant in service or other measure of enterprise cost and value? Where does the cash come from to pay the shortfall? Shareholders? No! Creditors? No! Efficiencies? Not likely!
Advertisers? Maybe! Bidders may rely on “two-sided” business models in which cost recovery responsibilities are shifted in part from subscribers to advertisers – as with newspapers, magazines, cable television and other information technology services. But, previous efforts with such a business model in the wireless broadband space provide little basis for optimism. On the face of it, there appear to be dim prospects indeed for generating substantial revenues from ads directed at consumers who for whatever reason opt to take a free, slower service rather than a reasonably priced, faster substitute available in the marketplace. More fundamentally, there is reason to doubt that the advertising model, so successful in Google applications designed for stationary wireline platforms, will be equally so in a wireless, mobile small receiver environment.
Will the cash come from other subscribers? Problematic! Suppose the winning bidder attempts to implement a “cross-subsidy” pricing model in which some consumers are taxed with higher than normal rates so that others may get free service. A 25% giveaway plan means that paying subscribers would have to pay three times as much as they would otherwise. Financial statements of current operators indicate normal returns and offer no encouragement to entrants looking to make monopoly-like profits from a subset of their subscribers. It is well established in theory, practice and in the FCC’s own findings that cross-subsidy business models are not sustainable in an unregulated, competitive market environment. There is nothing here to suggest an exception to that rule.
Question 4. What happens if the plan fails?
Previous FCC efforts to tailor spectrum awards to the business plans of special interests have failed. The most recent was the “D Block” auction in which Frontline, the company for which the rules were tailored, did not even bid, while other bidders found the uneconomic requirements in the license so daunting that they could not meet the Commission’s minimum bid requirement. The government still owns D block; the FCC is reconsidering the rules; charges of undue influence are still floating about; fingers are pointing in all directions; and, consumers and public safety are still waiting for the promised new and innovative services.
Defaults on obligations to the Treasury from winning bids are not uncommon. The most notable is the case involving NextWave’s failure to pay full value to the US Treasury for spectrum it won at auction. The case provoked a jurisdictional dispute (telecom law versus bankruptcy law), property rights disputes (who owns the spectrum won at auction), and other time and resource consuming litigation. Substantial associated costs were ultimately borne by consumers.
There are no guarantees that bidders’ promises will or can be realized, and the record to date of enforcing bidder commitments is discouraging. Cynics suspect there are folks lining up to exploit a possible “bait and switch” opportunity – making a politically attractive, but legally unenforceable set of commitments, but asserting an claim on ownership of the spectrum irrespective of the success of the initial business plan.
Martin’s proposal is a risky undertaking – some say extremely risky. Backers have the security of a claim on the value of the spectrum, even if the original plan fails and prior commitments are not met. Both taxpayers and consumers are uninsured. They will bear the costs of failure. Perhaps the imbalance could be remedied simply by putting into the license terms a statement to the effect that the winning bidder and licensee agrees to yield all claims on the spectrum should the terms and conditions agreed to not be substantially met.
Question 5. Will this plan truly create value for consumers?
The foregoing scratches the surface of uncertainty and concerns of savvy consumers about the prospect of success of a plan to auction spectrum conditioned on the winner agreeing to give away service. There are others. Indications are that the build-out requirements in the plan are very aggressive; that terms of the license may be impossible to enforce without time and resource wasting litigation; that lack of clear definition of licensee requirements will invite speculative gaming of regulatory processes; and, that threshold investment and sunk cost requirements combined with the reality of terms of the license will discourage serious bidders.
All in all, the proposed Advance Wireless Service III auction plan gives the lie to any pretension of a rational spectrum policy based on concerns to get spectrum out most quickly to entities that can put it to the quickest, most productive use for the benefit of American consumers. The plan has all the earmarks of wishful thinking without due diligence or consideration of the likely impact on consumers.
Armed with the facts and given a chance, consumers would overwhelmingly vote: No Deal!