In its “Consultation on Annual License Fees” for the 900 MHz, 1800 MHz, and 2100 MHz spectrum, published on 13 December 2024 (2024/25 Consultation), Ofcom presents its methodology and calculations regarding the selection of a discount rate for annualization to convert lump sum values (LSVs) into ALFs. Ofcom employs a similar methodology for estimating the discount rate as it did in the previous decision in 2021 (2021 Decision), which takes a cost of debt estimate based on observed debt yields and adjusts this figure by adding a risk-sharing premium. Applying this methodology, Ofcom finds the real post-tax discount rate has increased from 0.1% in its 2021 Decision to 1.7% in its 2024/25 Consultation, resulting in a corresponding increase in the annualization rate from 5.34% to 6.38%.

Virgin Media O2 engaged NERA to assess Ofcom’s approach for determining the annualization rate for the calculation of ALFs. In this report, we outline several flaws and inconsistencies within Ofcom’s method of estimating the annualization rate in the 2024/25 Consultation.

First, Ofcom disregards the conceptual relationship between capital market conditions and LSVs. The discount rate used by MNOs in determining the value of spectrum and placing bids in auctions is dependent on the capital market environment at the time of the auction. An increase in the discount rate leads to a decrease of the value of spectrum if all other inputs remain the same. It follows that if the capital market conditions defining the associated change in discount rates, auction results would be expected to change, too.

Between 2021 and 2024, the interest rate environments in the UK and in Europe underwent a fundamental shift, with the UK Bank Rate increasing from below 1% to more than 5%. Ofcom’s benchmark auctions (from which Ofcom derives the LSVs) predominantly took place in a capital market environment with low interest rates. Without adjusting auction results for an increase in the MNO’s discount rates, Ofcom overestimates the current market value of spectrum.

Hence, this fundamental connection between LSVs and discount rate should be recognized in determining ALFs. Ofcom can tackle this issue by either modifying the LSV to account for changes in the capital market environment or by altering the annualization rate (i.e., the discount rate used to convert the LSV into an ALF).

Second, we identified several inconsistencies in Ofcom’s derivation of the constituent parameters of the real post-tax discount rate:

• Ofcom underestimates expected CPI;
• Ofcom’s estimate of a CPI inflation risk premium is inconsistent with its inflation expectations; and
• Upper polar case is biased upwards due to the inclusion of unsystematic risk within Ofcom’s WACC.

Correcting for Ofcom’s inconsistencies in determining the constituent parameters, we find the real post-tax discount rate lies between 0.68% and 1.22% depending on the assumption about future CPI. Based on Ofcom’s assumptions on the ALF period and the tax adjustment factor, we calculate 5.82%–6.12% for the annualization rate, with a mid-point of 5.97%.