BEAD Pitfall: Overpaying and leaving money on the table

Bowling Green, Kentucky (February 9, 2023) – In my last post, I introduced a model BEAD grant scenario — a general way to envision what will happen when states begin making Broadband Equity, Access, and Deployment (BEAD) grants to internet service providers (ISPs) starting in 2024. That version had states doing a pretty good job of getting the work done without spending much more than they needed to.

But we can adapt the same model to illustrate a lot of different scenarios. This post is devoted to an important pitfall that could be very difficult for states to avoid: making BEAD grants that are too big.

Too big, in what sense? Bigger than is needed to get the job done. But the following model can make that clearer than any words could. Consider Figure 1. Again, the chart contains seven bars: (a.) capex (capital expenditure), (b.) PV (present value) of revenue, (c.) PV of opex (operating expenditure), (d.) willingness to invest (maximum, for a rational ISP), (e.) required subsidy (minimum), (f.) grant, and (g.) match.

Again, the ideal BEAD grant is roughly equal to the required subsidy. But in Figure 1, the BEAD grant is much larger.  

Figure 1: When states overpay for broadband projects and just subsidize ISP shareholders.

What’s wrong with that? One way to put it is that the state overpays for the project. You might say it “leaves money on the table,” creating a “windfall” for the ISP.

It’s good to be the ISP in Figure 1! It gets to build a valuable network, almost entirely with public money, and then own and operate it indefinitely, earning revenues well above operating expenditures, and making a large continuing profit. And it spent very little out of pocket to get into that advantageous situation. The large capex required was covered almost entirely by a state grant.

If the state had negotiated or designed its competitive grantmaking rules better, it could have gotten the same network built at a much lower subsidy cost. Even with a much smaller grant on offer, the ISP would still have undertaken the project. To cover the financing gap, it would have had to use retained earnings, or raise money from investors or bank loans. But it could have put in a lot of its own capital, and still made a decent ROI. That would have been a better deal for taxpayers. As it is, it’s the ISP’s investors who are getting the sweetheart deal.

On the positive side:

• The network does get built, and the residents of the target area get broadband access.
• The extra money isn’t exactly wasted, since it goes to the ISP’s bottom line. ISP shareholders are happy.

Still, overpaying for projects isn’t a great public policy outcome. How can states do better?

Information games

The underlying problem that’s likely to give rise to lots of outcomes like Figure 1 is that the state has no way to know what the real economic outlook of a given project really is. Many factors are certainly not known in advance, even to the ISP. But the state will almost always be in a worse informational position than the ISP, since it generally knows only what the ISP chooses to tell it.

Some claims can be checked. And some ISPs may have scruples about outright lying even if their claims can’t be checked. But there are lots of ways for ISPs to inform selectively, and to manipulate estimates and projections and forecasts that are ethically and/or legally within bounds. This gives ISPs lots of room to be strategic in what they induce the state to believe.

Let’s take a simple case. Suppose a state, trying to get the size of its broadband grants right, naively asks ISPs to estimate their capital expenditure, cost of capital, expected future revenue, and expected future operating and maintenance costs. It then calculates future net income, translates it to a present value using the cost of capital provided, translates that imputed willingness to invest from the capital expenditure, and then awards a grant sufficient to cover the difference. In theory, that procedure should ensure the optimal grant every time.

But how would a profit-seeking ISP respond? Anything it can reasonably do to increase its estimate of the capital cost to build a network will increase the grant size. Similarly, any overestimate of operating costs or the cost of capital, and/or underestimate of expected consumer revenue means a bigger grant.

One problem with these incentives is that the grants will be too big. Another problem is that the biggest profits will go to the most dishonest ISPs, the ones that cook the books the most.

That’s not to say that states should never base grant decisions on ISP-reported financials. Accounting standards and the threat of an ex post audit can put some bounds on how far ISPs can safely mislead the state to get more money. But smart BEAD grant program design will put in place other ways to discipline the size of grant requests. Competition is probably the best, when you can get it. Negotiation is a difficult fallback option. Meanwhile, the larger problem that can arise if the state overpays for projects is that it’s likely to run out of money before it has met its citizens’ needs for broadband.

If you overpay for projects, you might run out of money

As I said, if a state overpays for a grant project, the need still gets met. The network is built. A state broadband office daunted by the difficulties of discerning how much the ISP really needs might be tempted to just overpay, let the ISP walk away with a bit of extra profit, and call it a win. And sometimes that might work out just fine.

But the big downside is that overpaying to get some areas served might mean that other areas don’t get served at all. To see why, first consider Figure 2.

Figure 2: Sometimes with right-sized BEAD grants, universal access is achievable.

In Figure 2, the large circle in the center represents a state’s BEAD allocation. For simplicity, we assume here that the state has four unserved areas, in each of which there is an ISP willing to deploy. In this scenario, the state skillfully designs its grant offers so that each one is just a little bit more than the required subsidy to close the business case for deployment.

The match percentage varies, being quite a bit larger, for example, for Area 4, where prospects of profit from the built network justify less than half of the needed capital expenditure than for Area 1, where the ISP could afford to put in almost a two-thirds match. Together, the grants add up to almost the state’s entire BEAD allocation, but there’s enough to go around. This state’s well-managed BEAD program is on track to achieve universal broadband access.

Now look at Figure 3. Much is the same. Again, there are four unserved areas. Again, there are ISPs willing to deploy to them, but they need subsidies. The capex, anticipated revenue and opex, and required subsidy are the same as before. But this time, the state has been less skillful. It paid more than it needed to for each project, especially for Project 3, and consequently found itself making grant commitments that exceed its overall BEAD budget.

Maybe the state legislature will come to its rescue and vote the broadband office the extra funds — or something. If not, the state will have to say no to one of the projects and leave one of the areas unserved. It will fail to meet the BEAD program’s goal of universal broadband access.

Figure 3: But if the state overpays for projects, the money runs out and universal service is out of reach.

The National Telecommunications and Information Administration (NTIA) is going to try to prevent scenarios like Figure 3. If it foresees that the state is awarding grants in too generous a way, it might reject the state’s initial proposal, in which it announces its BEAD grantmaking procedures. State broadband offices need to be thinking about what the NTIA will accept, and a big job in the great BEAD planning year of 2023 is to come up with a grant program design that will persuade the NTIA that the state has a plan to achieve universal broadband access at speeds of at least 25/3 Mbps and preferably 100/20 Mbps. But beyond convincing the NTIA, the programs actually have to work.

That’s why all the economic analysis and information gathering in the BEAD planning phase is so important. States need to understand their broadband situation and prospects for expansion so they can make the best use of their funds.

Unfortunately, there’s no guarantee that even the most skillful state broadband office can succeed. U.S. Congress didn’t have limitless insight about the real cost of achieving universal broadband access when it designed the BEAD funding rules. Some states may just not have enough money to get 100/20 broadband everywhere. Other states may be able to achieve it with a lot of funds to spare for high wages, extra network resiliency, gigabit service for community anchor institutions, sweetheart bargains for low-income broadband customers, and digital inclusion programming through schools and libraries.

But the single-most salient reason to avoid overpaying for BEAD grant projects is to avoid running out of money before broadband needs are met.

About the Author: Nathan Smith is the Connected Nation Director of Economics and Policy. Dr. Nathan Smith is a PhD economist with a Masters in Public Administration, who wrote his dissertation on the economics of technology. He is an extensively published writer on public policy, technology and economics. After leading the state broadband office in Arkansas during the 2020 pandemic, where he channeled CARES Act funds to broadband projects, he moved to Connected Nation to help other states wrestle with the rewarding but tricky business of efficiently subsidizing cutting-edge, sustainable broadband expansion. He also helps write proposals and develop digital equity plans.