High-cost areas, match waivers, and the problem of commercial sustainability

Bowling Green, Kentucky, (March 14, 2023) - In the last post, I gave an example of a BEAD grant award that was too big. The state should have required more private matching capital. But sometimes, a nearly 100% subsidy is necessary in order to make any broadband deployment project happen at all. In this post, I’ll show why. It’s one of the special challenges that arises from trying to serve the highest-cost locations.

In the past, most state broadband grant programs could almost ignore the needs of the highest-cost locations. There were so many unserved areas that you could connect tens of thousands of households and have a major impact by focusing on the “low-hanging fruit,” while leaving lots of locations still unserved because the grant funding was insufficient to close the business case for broadband expansion projects there. Often, that was the best way to make metrics like number of locations served per grant dollar spent look attractive.

Under BEAD, it’s different. The National Telecommunications and Information Administration (NTIA) wants states to achieve universal broadband access. What that means — 25/3 Mbps vs. 100/20 Mbps, fiber vs. other “reliable” technologies vs. satellite and unlicensed fixed wireless — is a long story, but the goal is explicit in the Infrastructure Investment and Jobs Act (IIJA) statute, detailed in the notice of funding opportunity (NOFO), and emphasized in many public statements from the NTIA. States can expect the NTIA to scrutinize their BEAD plans to make sure they’re getting on track to achieve the universal access goal, so they need a plan for dealing with the highest-cost areas.

Two problems that arise from that are (a.) a need for match waivers and (b.) a risk of commercial unsustainability. The problems are subtly interrelated, in a way that the theoretical model I’ve been using can elucidate.

The theory of where it takes a large grant to close the business case

To understand the special problems of the highest cost areas, consider Figure 1. Broadband deployment in the area shown is pretty expensive (high capex). After construction, the network will barely break even, because the PV of revenue is only slightly more than the PV of opex. The ISP’s willingness to invest private matching capital is therefore almost negligible, and is far less than capex. Therefore, a large grant is needed.

A nuance that needs mentioning is that grants can be “large” in two related but different senses: (a.) relative to the number of locations served, and (b.) relative to capex. Only case (b.) triggers the need for a match waiver.

There can be cases where PV of revenue is much higher than PV of opex, so that willingness to invest is high, but exceptionally high capex requirements means that the subsidy cost per location is still high, even with a lot of private matching capital. Such projects may need to exceed the Extremely High Cost Per Location Threshold that the BEAD program requires each state to set, and yet not require any match waiver.

In other cases,  there may be negligible willingness to invest private matching capital because anticipated revenue barely exceeds anticipated opex, yet the capex required and the subsidy cost per location is low. Such projects would need a waiver of the normal minimum BEAD match of 25%, but they would not breach the Threshold.

In an area like that shown in Figure 1, the state has to cover almost all of the investment cost in order to induce an ISP to deploy. This is not leaving money on the table or giving undue profits to investors. It’s necessary to make it worth the ISP’s while to build at all. The trouble is that ISPs that don’t need match waivers in order to invest will often have an incentive to say that they do. Who doesn’t prefer a 100% subsidy to a 75% subsidy?

The state will need to be shrewd in awarding match waivers and large subsidies only where necessary. It looks obvious in the charts. But as I explained in the first post in this series, states are groping in the dark, and the key quantities they’d want to know about are not readily observable. States will never quite know, and it will take a lot of expertise even to guess, what construction costs, customer revenues, operating expenses, and costs of capital ISPs foresee when they apply for grants.

Meanwhile, there’s another problem that states need to watch out for. When an ISP really does require a match waiver, that could be a signal that the project is commercially unsustainable.

The problem of commercial sustainability

The BEAD program is a temporary program that is meant to solve a problem permanently. By 2030 or so, all the BEAD funds will be spent, all projects closed out, and grant performance monitoring will probably taper off. Yet the intent is that the networks will remain, for years, decades, generations, and universal broadband access will be here to stay. That might really work because, in many places, the networks, once built, will be able to pay their bills out of customer revenues.

But in other cases, they may not. Consider Figure 2.

The scenario in Figure 2 resembles the scenario in Figure 1 in its high capex, low expected customer revenue, high opex, and the infeasibility of mobilizing private matching capital for the project. The difference is that whereas in Figure 1, PV of revenue was a bit more than PV of opex, here it is considerably less. It follows that not only does the project fail to yield an adequate ROI, it’s not commercially worthwhile to operate and/or maintain after it’s built.

A rational, profit-maximizing ISP will either shut it down as soon as grant rules permit, or perhaps run it unmaintained until something breaks, and then shut it down. That’s a long-term policy failure for the BEAD program.

Just because a network is commercially unsustainable doesn’t mean that people in this area don’t need the broadband access. They do. And it doesn’t mean the state can’t induce an ISP to agree to build and operate the network. It might.

What it does mean is that the state can’t permanently solve the broadband access problem in this area with a one-time grant. The grant will need to be “too big” to fund the deployment. It will need to be more than the total capex. In effect, the ISP gets not only the full construction costs covered, but also a kind of endowment to cover, in advance, the extra opex that customer revenues won’t. And the trouble with that is, how do you guarantee that the ISP will continue to use the extra money to keep the network going indefinitely?

If a BEAD grant funds the construction of a commercially unsustainable network, it might solve the broadband access problem for a while. But the ISP will find that it can’t pay the bills with what it earns from customers. Sooner or later, it will want to shut the network down.

An efficient, permanent solution to the broadband coverage gap in areas like that shown in Figure 2 would need to involve ongoing subsidy support, such as the universal service subsidies that have long sustained many rural telephone networks. But that’s outside the scope of the BEAD program. It’s a bit unclear how state broadband offices will deal with the problem of commercial unsustainability. Hopefully, it’s not widespread.

Administrative lessons for high-cost areas

While policymakers still have a bit of fixing to do before America has a sustainable solution for universal broadband access, some administrative lessons can be drawn right now that can help state broadband offices get match waivers and avoid commercially unsustainable boondoggles.

First, states should signal to industry that they have a credible way to define capex and opex, and to monitor the use of BEAD grant funds so that they’re restricted to capex. Applying the capex/opex distinction involves some nuances.

For example, if a company buys a truck to help with construction (e.g., to haul fiber-optic cable), that can be legitimate capex, up to a point. But if, as is likely, the truck will have plenty of residual-use value after the project is finished, it’s not legitimate to charge the full price of the truck to any given broadband deployment project.

If ISPs know the state will be policing the capex/opex distinction, they’ll make sure they don’t inflate the capex cost of a project by including opex line items in the budget. That will block some commercially unsustainable projects and overstatements of the private matching capital that is being co-invested.

Second, any project that requests a waiver of the 25% BEAD match should be regarded as at risk of commercial unsustainability. In principle, if ISPs can’t use grant funds for opex, they shouldn’t want to use BEAD funds for commercially unsustainable networks. They’ll just lose money.

But they might choose to take a risk if they can always get out of a money-losing operation by abandoning the network, and/or they might hope to milk the grant by overcharging on the capex side in ways that cross-subsidize operations. In that case, the ISP might want to walk away from the network a few years later if grant funds have been spent, and revenues are disappointing.

A generous match is good evidence that the ISP is really committed to building and operating the network for the long haul. If the ISP is not willing to do that, the state should exercise heightened scrutiny.

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.