DIGITAL MIGRATION WORKING GROUP WORKING COMMITTEE REPORT ON ECONOMIC SCENARIOS AND CONSUMER ISSUES FOR DIGITAL MIGRATION IN SOUTH AFRICA

DIGITAL MIGRATION WORKING GROUP WORKING COMMITTEE REPORT ON ECONOMIC SCENARIOS AND CONSUMER ISSUES FOR DIGITAL MIGRATION IN SOUTH AFRICA 15 th November 2006

2 1. INTRODUCTION -------------------------------------------------------------------------------------------3 1.1 TERMS OF REFERENCE----------------------------------------------------------------------------------4 2. ECONOMIC MODEL ------------------------------------------------------------------------------------------7 3. ECONOMIC SCENARIOS -----------------------------------------------------------------------------------8 3.1 POLICY ASSUMPTIONS -----------------------------------------------------------------------------------8 3.2.1 IMPACT ON GOVERNMENT ------------------------------------------------------------------------- 10 3.2.2 IMPACT ON CONSUMERS --------------------------------------------------------------------------- 11 3.3 ECONOMIC ASSUMPTIONS---------------------------------------------------------------------------- 11 4. SCENARIO PLANNING ------------------------------------------------------------------------------------ 12 4.1 SCENARIO 1: THREE-YEAR DUAL ILLUMINATION --------------------------------------------- 12 4.2 SCENARIO 2: FIVE-YEAR DUAL ILLUMINATION------------------------------------------------- 19 4.3 SCENARIO 3: DELAYED DIGITAL MIGRATION--------------------------------------------------- 25 5. CROSS SECTIONAL ISSUES ---------------------------------------------------------------------------- 28 5.1 DIGITAL DIVIDEND---------------------------------------------------------------------------------------- 28 5.2 CONDITIONAL ACCESS --------------------------------------------------------------------------------- 28 5.3 REAL GDP GROWTH RATE ---------------------------------------------------------------------------- 29 5.4 LICENSED PAY-TV BOUQUETS ----------------------------------------------------------------------30 5.5 BROADCAST SERVICE COVERAGE ---------------------------------------------------------------- 31 5.6 NUMBER OF YEARS FOR NEW CHANNELS TO GAIN FULL COMPETITIVE POTENTIAL------------------------------------------------------------------------------------------------------- 32 5.7 LEAKAGES --------------------------------------------------------------------------------------------------33 5.8 MANUFACTURING AND SMME DEVELOPMENT ------------------------------------------------ 33 6. CONSUMER ISSUES --------------------------------------------------------------------------------------- 35 6.1 COVERAGE AND AFFORDABILITY ------------------------------------------------------------------35 6.2 ADDRESSING THE NEEDS OF VULNERABLE GROUPS--------------------------------------37 6.3 DIGITAL TELEVISION ADOPTION AND ROLLOUT COORDINATION ---------------------- 38 6.4 PUBLIC INFORMATION AND CONSUMER CONSULTATION--------------------------------- 39 GENESIS DIGITAL MIGRATION MODEL----------------------------------------------------------------- 40

3 1. INTRODUCTION This economics report sets out various scenarios for the migration to digital terrestrial television ( DTT ) in South Africa. As a result of delays in the commissioning of consultants to provide an adequate economic model to evaluate the economic implications of DTT migration, the economics committee has not been able to exhaustively address all the issues, which are set out in its terms of reference. However, the economics committee is of the view that the scenarios presented in this document provide a broad framework for the evaluation of the impact of DTT based on three alternative timeframe scenarios. Moreover, the model commissioned by the Digital Broadcasting Migration Working Group ( the WG ) is a useful analytical tool to assess the impacts of most key variables on the DTT process and should be used as such throughout the process of managing the switchover. The Economics and Consumer Issues Working Committee ( the ECWC ) recommends that, following consideration of these scenarios by government, an optimal timeframe scenario should be selected. After selection of the optimal timeframe scenario, the economics committee will be in a position to assist government, the regulator and the independent body 1, proposed by the working group, to use the model to provide a detailed analysis of the following: 1. The economic position of all stakeholders in the analogue environment (i.e. assuming no digital migration) 2. The comparative impact of digital migration in the optimal timeframe scenario on the economic position of each stakeholder using a variety of factors (e.g. different box costs, different numbers of channels, different levels of government subsidy) 3. The ideal economic framework (taking into account the impact on all stakeholders) for the optimal timeframe scenario. This would enable the preparation of a detailed strategy document for the rollout of DTT which would set out the government s policy position, provide the framework for 1 DBMWG Report section 5.1.2

4 ICASA s market studies and licensing processes, as well as inform the long-term business plans of broadcasters and signal distributors. It would also provide guidance to manufacturers and retailers and would form the basis of any industrywide initiative to formally cooperate in the rollout of DTT. 1.1 Terms of Reference The ECWC is one of the four working committees of the WG, established by the Minister of Communications ( the Minister ) in 2005. The WG was tasked with developing policy, content, economic and the technical recommendations towards a national strategy for the transition of broadcasting systems from analogue to digital broadcasting in South Africa. The respective committees were drawn from representatives of the broadcasting industry, Independent Communications Authority of South Africa (ICASA) (the regulator), government, civil society, organised labour and consumer groups at the DMWG inaugural meeting held on 26 August. Their terms of reference (TOR) were established at the same meeting, where the ECWC was tasked with building a business case for Digital Migration, considering the economics, fiscal, consumer and social impacts. This entailed; outlining cost factors, potential benefits and identifying economic risks and mitigating factors; establishing mechanisms or options of funding mechanisms for the digital migration process; considering dynamics that would facilitate consumer access, network expansion and service provision; identifying incentives and factors to stimulate demand and market uptake; and defining and assessing the current (and potential market)

5 The ECWC was specifically tasked to investigate and report on the following issues: a) Economic Issues: In what way will digital migration contribute to socio economic priorities of capital investment, job creation, economic distribution to all provinces, economic redistribution according to population demographics, rural population, previously disadvantaged communities, gender, etc? What investment incentives, support measures and consumer demand stimulation should be used to achieve rapid digital migration? What are the possible economic risks that may be associated with digital migration and how can these risks be addressed? What performance indicators should be used to monitor economic performance associated with digital migration? What capital expenditure and Human Capital investment is required for digital migration? What funding means should be used to capitalize digital migration? b) Consumer Issues: Should a percentage of the South African GDP be set aside for consumer research, education and diffusion to inform digital migration strategy and policy? If so, what would be a reasonable percentage that South Africa can afford? To achieve Universal Access and to prevent marginalization due to digitization, should the basic access devices such as set-top boxes ( STBs ) be leased or subsidized in a digitized environment? What other measures need to be put in place to ensure digitization enhances the provision of broadcasting services in South Africa? Should Government take steps to ensure that rural and provincial areas are guaranteed access to certain digital services in the future? If so, what services are necessary and what steps should be considered? Should Government take steps to facilitate arrangements for the broadcast of all free-to-air services on satellite platform? What approach should be taken for other non- commercial broadcast services and services which are only economic on a terrestrial platform? Are rural areas likely to face greater costs than urban areas in the transition from analogues to digital?

6 Are there any considerations that suggest that the transition to digital services in rural areas should follow a different time frame to that for the rest of the country? Are there any other issues facing rural areas in the transition to digital that should be taken into account in the policy development process? Demand for digital services? c) Related issues: Universal service and the address of digital divide, especially the rural areas should be the paramount social considerations. There should be intensive awareness to stimulate consumer uptake. Affordability of receiving devices should be ensured through subsidies. Digital broadcasting should facilitate the integration of audiences into the informational society. Economies of scale in digital consumer products. Low cost receiving devises. Effective public communication.

7 2. ECONOMIC MODEL The ECWC established the need for market and feasibility modeling to determine the economic viability of digital migration in relation to the television market in South Africa, taking the following into account; the impact of the switchover process, the feasibility of new television services (national or regional), new television services likely impact on incumbents, barriers to market entry and their mitigation, as well as incentives to promote both consumer adoption of and broadcasters migration. The economic model was to provide the following. a. Assumptions and scenarios for digital broadcasting in South Africa. This entailed a probability and an impact assessment on various scenarios on analogue television, DTT, as well as the existing subscription direct-to-home ( DTH ) satellite network. The later already has 100% coverage and mainly caters for the upper LSMs on a subscription basis. This needs to be counterbalanced against the fact that lower LSMs would probably not be able to afford a STB. b. Modelling the impact of the four major cost drivers, that is, transmission infrastructure, STBs, rollout resource requirements, and content. c. Modelling the impact of cost drivers for all the scenarios in (a) above, at a Macro level, broadly defined as capital Investment and operating costs. d. Examining possible funding options for the above scenarios incorporating universal service levies as a potential funding option for digital migration. e. Examining content and STB costs and other demand stimulation measures, considering the pros and cons of the various models, the costs of marketing and creating awareness, as well as the free rider problem in marketing.

8 3. ECONOMIC SCENARIOS Forecasting and scenarios are based on the following assumptions: 3.1 Policy Assumptions a) Set-top box take-up will be affected by the cost of the box to the consumer and the extent to which this will provide a variety of channels compared to the analogue market. It is assumed that the lower the cost of the box the higher the take-up rate will be. The cost is varied according to economic scenarios like technical specifications of the basic box, the extent to which costs drop over time as demand increases; as well as the extend and nature of government STB subsidies. It is also assumed that increased number and variety of channels will accelerate adoption. This will also be determined by the nature of these new channels, the cost of establishing and operating such channels and the extent to which their introduction would affect the viability of incumbent broadcasters. b) The migration process will involve a period of dual illumination of existing analogue services together with the introduction of new services and that there are three timeframe options for this dual illumination period: A short defined dual illumination period which will begin in 2008 and terminate in 2010 to finalise the process prior to the World Cup; A longer defined dual illumination period possibly terminating in 2012; A longer defined dual illumination period with a delayed start date of 2010 and terminating in 2015. The purpose of the delayed start date is to allow set top box pricing to decline to more affordable levels for the benefit of government and consumers. 3.2. Set-top Box Costs The unique socio-economic make-up of South Africa makes the price of the set-top box critical. It is assumed that the lower the cost of the box, the higher the take-up rate will be. The cost of the set-top box also has fiscal implications for government as it determines the level of subsidies to ensure take-up. It also has implications for consumer choice and affordability. The price of the set-top box involves a range of economic scenarios including:

9 a. the technical specifications of the basic box; b. the extent to which costs drop over time as demand increases; and, c. the extent to which government subsidises the box and the nature of such a subsidy. As the single biggest driver of STB take up, the box cost would have to be extremely low to be affordable to the bulk of the population. One technical decision which must be taken is whether DTT will be rolled out in South Africa on MPEG-2 (technology which is currently widely available) or MPEG-4 (a new technology which is presently used only in the upper end of the market and which is therefore currently more expensive). MPEG-4 is more spectrum efficient and will enable South Africa ultimately to roll out DTT in high definition. At current market prices, a basic MPEG-2 box costs R440 (ex-factory). The cost of a basic MPEG-4 box is R560 (ex-factory projected at 2008 prices). It is expected that MPEG-4 costs will decline as the standard is adopted, to the extent that in approximately 2012 the price difference between MPEG-4 and MPEG-2 boxes will be negligible. Figure 1: Projected cost of MPEG-2 vs. MPEG-4 set-top boxes

10 For the purpose of illustrating the effect various technologies and technical specifications have on the price of the box and how this in turn impacts consumers and the government, an MPEG-2 box, basic MPEG-4 (Entry level) box and an e- Government and CA capable MPEG-4 (Level1A DTT) box were modelled in terms of the three scenarios depicted in section 4 of this document. The outcomes of the settop box modelling is as follows: Scenario 1 (short dual illumination): STB Type Cost Estimated Retail price (at commencement date - 2008) HHs above threshold in 2008 HHs below threshold in 2008 NPV of gov't subsidy costs to HH below threshold (Rm) MPEG-2 $55 R 650 3,400,000 4,000,000 R 2,200 Entry level (MPEG-4) $70 R 850 3,000,000 4,400,000 R 3,200 Level 1A DTT (MPEG-4) $74 R 890 3,000,000 4,400,000 R 3,400 Scenario 2 (longer dual illumination): STB Type Cost Estimated Retail price (at commencement date - 2008) HHs above threshold in 2008 HHs below threshold in 2008 NPV of gov't subsidy costs to HH below threshold (Rm) MPEG-2 $55 R 650 3,400,000 4,000,000 R 1,750 Entry level (MPEG-4) $70 R 850 3,000,000 4,400,000 R 2,500 Level 1A DTT (MPEG-4) $74 R 890 3,000,000 4,400,000 R 2,660 Scenario 3 STB Type Cost Estimated Retail price (at commencement date - 2010) HHs above threshold in 2010 HHs below threshold in 2010 NPV of gov't subsidy costs to HH below threshold (Rm) MPEG-2 $55 R 500 4,000,000 3,600,000 R 1,050 Entry level (MPEG-4) $70 R 650 3,600,000 4,000,000 R 1,500 Level 1A DTT (MPEG-4) $74 R 680 3,600,000 4,000,000 R 1,550 3.2.1 Impact on Government Assuming that government subsidies to households below the affordability threshold will be 100%, the different technical specifications and associated costs of the three different boxes impact on the Net Present Value (NPV) of government subsidies. In scenario 1 the difference in subsidy required between the lowest (R2.2bil) and highest (R3.4bil) level box is R1.2billion. In scenario 2 this difference is approximately R900million (R1.75bil R2.6bil) and in scenario 3 the difference is R500million (R1.05bil R1.5bil).

11 3.2.2 Impact on Consumers Apart from the MPEG-2 option in scenario 3, all three scenarios are characterised by the fact that 4 million or more households cannot afford the cost of a set-top box. In all three scenarios between 3 million and 4 million can however afford the set-top boxes but in scenario 1 and 2 this figure is closer to 3 million. This clearly reflects the impact that the set-top box price and government s subsidy policy will have on the take up of set-top boxes. 3.3 Economic Assumptions Real annual GDP growth rate (%) 4% Inflation-adjusted discount rate (%) 4% TV advertising spend annual growth rate (%) (set at GDP growth) 4% Potential regional TV ad spend pool 2006 (Rm) 200 National-Regional cannibalization per additional channel (% of regional TV pool) 2% Period for new channels/bouquets to gain full competitive potential (years) 5 Government annual marketing and administration of migration (Rm) 100 Household affordability threshold level (STB as % of annual income) 2.5% Base annual adoption rate for those above affordability threshold (%) 2% Increase (decrease) in base adoption rate due to one additional channel (%) 3.0% Increase (decrease) in base adoption rate due to each R50 difference in STB price 0.5% (%) 2010 World Cup boost effect 5.0% Annual growth in TV households (%) 1% STB price decline per annum from start of digital migration (%) 5% No. of years experiencing STB price decline 5

12 4. SCENARIO PLANNING In order to test the various economic scenarios for digital migration, the economics committee has used the three dual illumination timeframe options as three broad scenarios. In each of these scenarios, the committee has used the economics model to assess the extent to which the take-up factors - box cost and additional channels support the timeframe under consideration. The set-top box price, modelled in these scenarios, is based on a basic MPEG-4 box. Adding or removing features will increase or decrease the price of the box and effect the impact on stakeholder, as depicted in paragraph 3.2 The figures reported in this section are based on figures made available to the WG and give an indication of the economic impact on the various stakeholders in each case. They are not expected to be precise, and hence the numbers are rounded off. 4.1 Scenario 1: Three-Year Dual Illumination This timeframe is driven by the policy objective of making DTT as widely available as possible by the 2010 World Cup. Given the short timeframe, this allows little time for a consumer-driven migration initiative and requires a high level of government intervention. To achieve this objective, the following measures would have to be implemented: Digital migration begins in 2008 and ends 2010 STB price: R850 (MPEG-4, not e-government capable, embedded software, CA not imbedded) decreasing to R638 in 2013 Standard subsidy: 0% STB subsidy for households below affordability threshold: 100% Subsidisation strategy for households below affordability threshold: end of migration period (strategy 1) Number of new channels: 4 in total New channel types: 2 SABC regional channels, 1 SABC national public broadcast channel and 1 e.tv national channel

13 a) Impact changing the number channels has on adoption rate (for HH that can afford STB) Adoption in Each Period (year end) Adoption in Each Period (year end) 8,000,000 120% 7,000,000 120% Households 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 100% 80% 60% 40% 20% Households 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 100% 80% 60% 40% 20% - 0% - 0% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Year Figure 2: Base scenario adoption rate Figure 3. One new channel (total of 5 new channels) Note: the figures above show the annual adoption numbers in blue and the cumulative adoption path in red. It is assumed that all households that can afford an STB and have not migrated will adopt in the final year of dual illumination. Adding one more channel does not have a material impact on the adoption outcome when there is a short dual illumination period. Enticing households to adopt by offering additional channels (Figure 3) impacts only on those households that can afford to purchase the STB in the first place. With the STB price set at R850 (no subsidy), the model indicates that approximately 4 400 000 households will be unable to afford to purchase a STB in 2008 2. This translates into 60 per cent of total households. Offering new channels makes no difference to this group. 2 This calculation is based on assuming a threshold level of 2.5%. With a STB price of R850, this threshold level translates into an annual income of R34 000. The model thus assumes that in 2008 households who earn an annual income of R34 000 or less will be unable to purchase the STB.

14 b) Impact of changing number of channels on broadcaster feasibility: 1600 1400 1200 1000 800 600 SABC e.tv entrant M-Net 400 200 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020-200 Figure 4: Base Scenario of 4 additional channels Note: this figure presents estimates of the net operating profit before interest and tax (EBIT) for the incumbent operators From the graph above we note a significant decline in the net operating profit of broadcasters from 2008 to 2011. This decline is a consequence of higher transmission costs during the period of dual illumination as broadcasters incur both analogue and digital transmission costs. Additional content costs incurred by SABC and e.tv as a result of producing the additional channels aggravates the slump in profits. 1600 1400 1200 1000 800 600 SABC e.tv entrant M-Net 400 200 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020-200 Figure 5: Impact of adding one additional SABC channel

15 1400 1200 1000 800 600 400 SABC e.tv entrant M-Net 200 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020-200 -400 Figure 6: Impact of adding two additional SABC channels: What is evident from the graphs above (Figures 5 & 6) is that adding channels does not benefit incumbent broadcasters. This is because, in introducing such channels, the incumbents incur additional content and transmission costs. While new channels will eventually attract revenue, it takes time for them to gain full competitive potential. Given that with this short migration period households will adopt in 2010 anyway, the benefit of inducing take-up and consequently increasing the number of digital viewers is outweighed by the costs associated with an additional channel. In addition, the introduction of new channels results in a cannibalization of existing television adspend, resulting in existing channels being worse off. 1200 1000 800 600 400 200 SABC e.tv entrant M-Net 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020-200 -400-600 Figure 7: Impact overt time of moving SABC national public channel to a new commercial entrant

16 Broadcasters Base Entrant SABC NPV Costs (Rm) 43,103 41,395 NPV Revenues (Rm) 50,164 47,539 NPV Net position (Rm) 7,061 6,144 Average net operating margin (%) 14.1% 12.9% Years with operating loss 0 0 e.tv NPV Costs (Rm) 8,013 7,959 NPV Revenues (Rm) 12,410 11,647 NPV Net position (Rm) 4,397 3,688 Average net operating margin (%) 35.4% 31.7% Years with operating loss 2 2 M-Net NPV Costs (Rm) 3,696 3,694 NPV Revenues (Rm) 4,557 4,482 NPV Net position (Rm) 861 788 Average net operating margin (%) 18.9% 17.6% Years with operating loss 1 1 Entrant NPV Costs (Rm) - 3,508 NPV Revenues (Rm) - 3,839 NPV Net position (Rm) - 332 Average net operating margin (%) 0.0% 8.6% Years with operating loss 0 4 Table 1: Impact of moving SABC channel to new commercial entrant In the event that new entrants (independent of the incumbent broadcasters) are introduced in the market, this will negatively impact on incumbent broadcasters. This is because the new entrant is a national commercial channel and will therefore compete for advertising revenue which will be cannibalised from the channels of the incumbent broadcasters. Figure 7 and Table 1 above clearly shows the impact the introduction of a national commercial channel has on the average net operating margins of the incumbent broadcasters. c) Impact on adoption of providing a standard set-top box subsidy of 20% Adoption in Each Period (year end) Adoption in Each Period (year end) 8,000,000 7,000,000 Households 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 Households 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000 - - 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Year 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Year Figure 8: Household adoption at 0% subsidy Figure 9: Household adoption at 20% subsidy

17 Note: the figures above show the annual adoption numbers in blue and the cumulative adoption path in red. The standard subsidy is a government subsidy which applies to all STBs and which is introduced at the beginning of the dual illumination period. This is distinct from the government subsidy to households who fall below the affordability threshold. Increasing the standard subsidy reduces the final cost of all set-top boxes to the consumer and therefore enables a greater number of households to purchase the STB. A standard subsidy of 20% reduces the number of households that are below the affordability threshold from 4 400 000 households to 4 100 000 (Figure 9). In addition, it increases the rate of take-up by those households who can afford to adopt so that more of them purchase set-top boxes in 2008 and 2009. The cost to government of a 20% standard subsidy is R570m. The standard subsidy will bring the STB within the affordability range of more households. However, the introduction of the standard subsidy from the start of dual illumination results in an increase to government in subsidisation costs. The net effect is an increase in government costs of R300m (at NPV). Given that this extra expenditure incurred by government has no significant impact on the adoption rate, subsidising those who can afford STB does not appear to be an optimal strategy in this scenario. d) Subsidisation strategy for households below affordability threshold Adoption in Each Period (year end) Adoption in Each Period (year end) Households 7,000,000 6,000,000 5,000,000 4,000,000 3,000,000 2,000,000 1,000,000-2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 120% 100% 80% 60% 40% 20% 0% Households 4,500,000 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000-2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 120% 100% 80% 60% 40% 20% 0% Year Year Strategy 1(subsidise at end) Strategy 2(during migration period) Figure 10 Impact of changing subsidisation strategy for those falling below affordability threshold Note: the figures above show the annual adoption numbers in blue and the cumulative adoption path in red.

18 The graph above shows the impact of a government subsidy to households who fall below the affordability threshold. The first graph (Strategy 1) indicates the effect of such a subsidy if it is introduced only in the final year of the migration period. The second graph (Strategy 2) indicates the impact of the subsidy if it is introduced during the migration period. In Strategy 1, subsidising these households at the end of the period means that there is a limited take-up rate before the subsidy becomes effective. In Strategy 2, which reflects an annual subsidy rate of 30% of these households, the subsidy increases the number of households adopting each year. This is because most households fall below the affordability threshold and so migrating this group prior to the cut-off date has a large impact on the take-up rate. Changing the subsidisation strategy only marginally increases the cost to government of subsidising this group from R3 200m to R3 300m (at NPV). The reason for this is two-fold. Firstly, the payments are brought forward, which increases the NPV cost. Secondly, given that the price of the STB falls with time, subsidising the group during the migration period implies that the government is subsidising a higher-priced STB, which will clearly increase costs. However, given that the dual illumination period is very short in this scenario, the difference in set-top box costs at the start of the process compared to the end, is not as large as it would have been in a scenario with a longer dual illumination period. Changing the subsidisation strategy has no impact on the incumbent broadcasters net positions. Given that the incumbents ad revenue is split between both analogue and digital viewers, increasing the number of households that have migrated simply changes the ratio of analogue to digital viewers, but the net effect on advertising revenue is zero. However, if an incumbent added a new digital-only channel, the incumbent would prefer subsidisation strategy 2 so that this new channel has a larger base of digital viewers to draw from. Similarly, if a new entrant was licensed to provide a digital-only service subsidisation strategy 2 is also better for the entrant.

19 Summary Conclusions: The short dual illumination period is costly for government, as it must provide largescale subsidies for STBs for those households who cannot afford to adopt. Regardless of the subsidisation strategy selected, these costs are high because they are brought forward (increasing the NPV of the costs) and because the drop in STB costs cannot be fully realised over this short period 3. From the broadcaster s perspective, this approach is preferable because households will have adopted by 2010 regardless of the number of channels offered. This implies that broadcasters do not have to entice households to migrate by offering new channels and hence do not have to incur the additional costs associated with additional channels. A second benefit for broadcasters of a short dual illumination period is the reduction in transmission costs, as broadcasters will incur both analogue and digital transmissions costs for a shorter period of time. 4.2 Scenario 2: Five-year Dual Illumination Scenario 2 differs from Scenario 1 in that the dual illumination period is for five years and eight new channels are introduced instead of 4. Digital migration begins in 2008 and ends 2012 STB price: R850 (MPEG-4, not e-government capable, embedded software, CA not imbedded) decreasing to R638 in 2013 Standard subsidy: 0% STB subsidy for households below affordability threshold: 100% Subsidisation strategy for households below affordability threshold: end of migration period (strategy 1) Number of new channels: 8 (14 channels in total: 6 channels per broadcast service (B.S.) (Free-to-air services on B.S1 and B.S. 2 and M-Net and CSN on B.S. 3). New channel types: 2 SABC regional channels, 2 SABC national public broadcast channel, 1 e.tv national commercial channel, 2 entrant national commercial channels and SABC national commercial channel 3 This depends on the STB which is selected as the standard box. See paragraph 3.2 (above).

20 a) Impact of changing number of channels on the adoption rate (for households that can afford STB): Adoption in Each Period (year end) Adoption in Each Period (year end) Households 4,500,000 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000-2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 12 10 80 60 40 20 0% Households 4,500,000 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000-2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 12 10 80 60 40 20 0% Year Year Figure 11: Base scenario adoption rate Figure 12: One new channel (total of 9 new channels With eight new channels (Figure 11) driving the adoption rate, all the households who can afford to adopt do so by 2011, even thought the theoretical final year in terms of the model is 2012, with 26% adopting in 2011. This is in contrast to scenario 1, where approximately 72% of those households who could afford the STB adopted in the final year 4. Reducing the number of new channels slows down the adoption rate so that more households adopt later in the migration period: for example, reducing the number of channels to 7 implies that 10% (of affordable households) adopt in 2012, while 6 new channels results in 15% adopting in 2012. Once again, given that the majority of households fall below the affordability threshold, the extent to which the number of channels offered affects the take-up rate is small as a percentage of total households. For example, reducing the number of new channels from 8 to 7 implies an additional 2% of total households will delay their adoption to the final year as a result of one less channel. Thus, as in Scenario 1, given that there is a huge group of households that will not adopt no matter how many channels are offered, the impact of adding new channels is limited. 4 Even with 8 new channels in scenario 1, 48% adopt in final year (2010).

21 b) Impact of changing the number of channels on broadcaster feasibility: 1200 1000 800 600 400 200 SABC e.tv entrant M-Net 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020-200 -400-600 -800 Figure 13: Base Scenario In Figure 13 above, we again, note the significant drop in the incumbent broadcasters operating net profit during the period of dual illumination. Any new entrant will also face significant losses before breaking even. This is as a result of start-up costs and the fact that new digital channels share only in the number of migrated households the entrant s success depends heavily on the number of households which have migrated to digital. 1200 1000 800 600 400 200 0-200 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 SABC e.tv entrant M-Net -400-600 -800 Figure 14: Impact of adding one additional SABC channel

22 1400 1200 1000 800 600 400 200 SABC e.tv entrant M-Net 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020-200 -400-600 -800 Figure 15: Impact of adding two additional SABC channels Broadcasters 10 new channels 9 new channels 8 new channels 0 new channels SABC NPV Costs (Rm) 48,863 47,426 46,219 42,031 NPV Revenues (Rm) 50,448 50,005 49,538 50,103 NPV Net position (Rm) 1,585 2,579 3,319 8,072 Average net operating margin (%) 3.1% 5.2% 6.7% 16.1% Years with operating loss 6 6 3 0 e.tv NPV Costs (Rm) 7,097 7,247 7,261 6,315 NPV Revenues (Rm) 9,078 9,272 9,476 9,098 NPV Net position (Rm) 1,981 2,025 2,215 2,783 Average net operating margin (%) 21.8% 21.8% 23.4% 30.6% Years with operating loss 1 2 2 0 M-Net NPV Costs (Rm) 3,774 3,774 3,775 3,791 NPV Revenues (Rm) 4,278 4,299 4,322 4,779 NPV Net position (Rm) 504 525 547 988 Average net operating margin (%) 11.8% 12.2% 12.6% 20.7% Years with operating loss 1 1 1 0 Entrant NPV Costs (Rm) 4,777 4,875 4,879 - NPV Revenues (Rm) 4,328 4,458 4,598 - NPV Net position (Rm) -449-416 -281 - Average net operating margin (%) -10.4% -9.3% -6.1% 0.0% Table 2: Impact of introducing new channels The values for these results are presented above (10 new channels corresponds to 2 additional SABC channels being added, 9 new channels corresponds to 1 additional

23 SABC channel being added, 8 new channels is the base scenario case while 0 new channels assumes no new channels are added). What is evident from Figures 14 and 15 as well as Table 2 above is that adding new channels is not beneficial for the incumbent broadcasters adding the new channel (SABC in this example) For example, in the SABC s case, the more channels it has the higher its revenue as the additional channels draw in a larger share of the revenue pool. However, its costs increase as it has to incur additional content costs. The net impact is a decline in its operating margin. For the other incumbent broadcasters, additional SABC channels impacts negatively on their operating margin. Their costs are reduced because transmission costs fall as the number of channels per B.S. increases, but the negative impact on their revenue as they lose share of advertising revenue to the SABC outweighs any such positive impact on costs. For any new entrant, delaying entry into the market is beneficial. This is because the new entrant shares only in the number of migrated households. This is illustrated in the table below (dates indicate year of entry): Entrant 2,008 2,010 2,012 NPV Net position (Rm) -759-281 -147 Average net operating margin (%) -14.5% -6.1% -4.0% Years with operating loss 5 4 4 Table 3: Impact of delayed entry for new entrant c) Impact on adoption of increasing standard subsidy from 0% to 20% Adoption in Each Period (year end) Adoption in Each Period (year end) Households 4,500,000 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000-2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Year 12 10 80 60 40 20 0% Households 4,500,000 4,000,000 3,500,000 3,000,000 2,500,000 2,000,000 1,500,000 1,000,000 500,000-2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Year 12 10 80 60 40 20 0% Figure 15: 0% subsidy Figure 16: 20% subsidy

24 As is the case in Scenario 1, increasing the standard subsidy decreases the price of the STB to the consumer and therefore increases the number of households that can afford the STB purchase. The impact on adoption is that with this subsidy only 21% (Figure 15) of households delay adoption until 2011 even though they have until 2012 to do so, whereas without the subsidy 26% (Figure 16) of households delay adoption until 2011. Once again, given that the majority of households fall below the affordability threshold, the impact of the standard subsidy on the number of adopted households is small as a percentage of total households. 5 For example, not having the standard subsidy implies that an additional 2% of total households will delay adoption until 2011. The implications of this subsidy on government costs are the same as in Scenario 1. Subsidising those who can afford STB (by providing a standard STB subsidy) again does not appear to be an optimal strategy in Scenario 2 because the additional channels offered by broadcasters will induce households to adopt anyway. d) Impact of changing subsidisation strategy for those falling below affordability threshold As in Scenario 1, a full subsidy (rolled out during the migration period) for those households who cannot afford to purchase a STB dramatically increases the number of households adopting each year. Changing the subsidisation strategy from Strategy 1 to Strategy 2 increases the cost to government of subsidising this group from a net present value of R2500m to R3200m (at a rate of 30% per annum). The reason for this increase in costs is the same as in Scenario 1. There are, however, two differences in the magnitude of these values compared to Scenario 1 (where costs increased from R3200m to R3300m): (i) In Scenario 2, changing to strategy 2 increases government costs by R700m, while in Scenario 1, the difference in costs is only R100m. This is because in Scenario 1, the dual illumination period is very short; therefore bringing forward the payments will not have a large impact on the NPV of costs. (ii) In Scenario 1, with the shorter dual illumination period, government subsidisation costs are larger. This is because the costs are brought forward and because the fall in STB price cannot be realised over this short period. 5 As in Scenario 1, with the STB price set at R850 approximately 4400 000 households will be unable to afford to purchase a STB in 2008.

25 Summary Conclusions: A longer period of dual illumination reduces government subsidy costs to households who cannot afford STBs. Since broadcasters need to offer new channels to motivate consumers to adopt, broadcasters bear the burden of migrating those households who can afford the STB. Additional channels negatively impacts broadcasters as they incur additional content costs and increased transmission costs while simultaneously losing advertising revenue to the new channels. 4.3 Scenario 3: Delayed Digital Migration This scenario involves delaying the start date for digital migration in order to take advantage of the decrease in STB costs 6. The switch-off date would be determined when a sufficient number of consumers have migrated but would be no later than 2015. While many of the benefits and requirements of Scenario 2 apply also to this scenario, it is distinct in that it would be driven primarily by consumer take-up and it would result in the unavailability of analogue frequencies for new services. Digital migration begins in 2010 and ends 2015 STB price: R650 decreasing to R488 in year 2015 Standard subsidy: 0% STB subsidy for households below affordability threshold: 100% Subsidisation strategy for households below affordability threshold: end of migration period (strategy 1) Number of new channels: 6 (12 channels in total: 6 channels per B.S.1 and B.S.2) New channel types: 2 SABC regional channels, 1 e.tv national commercial channel, 1 SABC national commercial channel and 2 entrant national commercial channels This scenario differs from Scenario 2 in that the period of dual illumination is for six years and the commencement of digital migration is delayed from 2008 to 2010. The consequence of this is that the starting STB price is set to R650 because STB costs drop over time. The second major departure from Scenario 2 is that only 6 new channels are offered and only two B.Ss are used. 6 This depends on the STB selected. See paragraph 3.2 (above). This scenario is most cost-effective for consumers and government if the intention is to introduce an affordable MPEG-4 STB.

26 The other difference to Scenario 2 is the placement of channels on the B.S. Transmission costs per channel fall as the number of channels placed on a B.S. increase because the costs are shared across the channels. Thus, reducing the number of B.Ss used from 3 to 2 will reduce the transmission cost per channel. Given that only 6 new channels are assumed in this scenario, these channels can be accommodated on 2 B.S.s. This will benefit broadcasters as transmission costs are reduced. As a rough estimate, moving four channels to B.S. 3 increases digital transmission costs from R500m to R600m in 2010. Transmission companies are largely unaffected as they are modelled on a cost-plus basis. With the delayed approach, the model shows that in theory all households will have adopted by 2014, that is, within five years even though they have six years to adopt. The advantage of delaying the commencement of digital migration is that the STB price is reduced, which will naturally speed up the rate of adoption, without requiring a subsidy. A further advantage is that growing incomes will move households above the threshold. The net effect is that in 2010, 4 000 000 households fall below the threshold, which constitutes 52% of total households. This figure is lower than the 4400 000 households (or 60% of total households) that are below the threshold in 2008 under Scenario 2. Furthermore, fewer channels need to be offered to incentives take-up: even if the number of new channels is reduced to 5, all households will adopt by 2014. This is because the lower-priced STB will induce take-up, lowering the number of channels needed to get everyone to migrate. In terms of subsidy costs to households below the affordability threshold, this delayed approach is also preferable. The NPV of cost to government with strategy 1 is R1500m, while the NPV of costs employing strategy 2 is R2000m. These costs are significantly lower than in the other two scenarios. This is because the STB price itself is substantially lower and that subsidy payments are delayed, reducing the NPV of the costs. This delayed approach appears to mitigate the negative impact of digital migration for both government and broadcasters. The other difference from Scenario 2 is the placement of channels on the B.S. Transmission costs per channel fall as the number of channels placed on a B.S. increase. Thus, reducing the number of B.Ss used from 3 to 2 will reduce the transmission cost per channel. Given that only 6 new channels are assumed in this

27 scenario, these channels can be accommodated on 2 B.S.s. This will benefit broadcasters as transmission costs are reduced. As a rough estimate, moving four channels to B.S. 3 increases digital transmission costs from R500m to R600 in 2010. Summary Conclusions: Delaying digital switch-on to 2010 significantly reduces government subsidy costs to households who cannot afford STBs as a result of the reduction of STB prices over time. Due to the lower STB prices more households can afford to migrate while more households also fall above the affordability threshold as a result of GDP growth. Furthermore, fewer channels need to be introduced to entice take-up with less impact on the market.

28 5. CROSS SECTIONAL ISSUES 5.1 Digital Dividend The value of the digital dividend is reliant on a national spectrum pricing policy that should be informed by a national spectrum policy developed by government. The national spectrum policy should govern equitable access, affordability and efficient usage of the entire radio frequency spectrum to avoid a piece-meal or ad-hoc approach. The ECWC was not mandated to develop a pricing policy and therefore the value of the digital dividend is derived from the following assumptions: Frequency freed up for sale (MHz) 100 Lump sale price for spectrum per MHz (Rm) 20 Annual price for spectrum per MHz (Rm) 2 Based on these assumptions, the NPV of the digital dividend under the three scenarios are: Scenario 1 Scenario 2 Scenario 3 R2980m R2530m R1915m The progressive reduction in the dividend from Scenario 1 to Scenario 3 is because the payment received from the sale of spectrum is delayed, which reduces the NPV of this revenue source. Thus, while Scenario 1 implies the highest costs for government, it also results in higher revenue from the sale of spectrum. However, on balance it would seem that the reduction in the NPV of costs for government in Scenario 3 far exceed the reduction in the NPV of revenues (a drop of roughly R2bn in costs compared to R1bn in revenues). 5.2 Conditional Access Should the decision be taken that CA be included in the minimum specification of the basic STB the following should be taken into consideration:

29 a. Including CA in the minimum specification adds approximately R20.00 (retail) to the cost of the box. Both the consumer and government who will be subsidising the STB will be affected by this increase. b. Activating CA adds proprietary and royalty costs to be paid by the broadcaster(s) concerned. c. Activating CA on the basic box that will be distributed to the majority of households in South Africa will require that the industry carefully cooperate and coordinate efforts to minimise errors on the system in order to ensure that large sections of the population don t lose services. The independent industry body proposed by the WG will play a critical role in such an instance. d. Active CA on the basic box requires that households receive support through help-lines, call-centres, database management and a technical support network. This could add considerable operation cost to government and broadcasters. Estimates show the cost could be in the region of R100 million per annum. e. It is the view of some, but not all stakeholders, that CA on the basic box does have the advantage of allowing the industry and government to develop a comprehensive database on TV households for use in communications, licence fee collection, etc. 5.3 Real GDP growth rate The default real GDP growth rate is 4% per annum. The GDP growth rate impacts on broadcaster s revenues and on the adoption rate. The following table summarises the impact of changing the GDP growth rate to 2% and then 6% in Scenario 1.

30 Broadcasters 4% 2% 6% SABC NPV Costs (Rm) 43,103 43,035 43,184 NPV Revenues (Rm) 50,166 46,741 54,203 NPV Net position (Rm) 7,063 3,707 11,019 Average net operating margin (%) 14.1% 7.9% 20.3% Years with operating loss 0 1 0 e.tv NPV Costs (Rm) 8,013 7,892 8,156 NPV Revenues (Rm) 12,413 10,686 14,458 NPV Net position (Rm) 4,400 2,794 6,302 Average net operating margin (%) 35.4% 26.1% 43.6% Years with operating loss 2 2 1 M-Net NPV Costs (Rm) 3,696 3,690 3,703 NPV Revenues (Rm) 4,557 4,382 4,763 NPV Net position (Rm) 861 692 1,060 Average net operating margin (%) 18.9% 15.8% 22.2% Years with operating loss 1 1 1 Entrant NPV Costs (Rm) - - - NPV Revenues (Rm) - - - NPV Net position (Rm) - - - Average net operating margin (%) 0.0% 0.0% 0.0% Years with operating loss 0 0 0 Table 3: Impact of GDP growth on broadcasters Given that in the model advertising revenue grows at the GDP growth rate, we find that revenue is particularly sensitive to the GDP growth rate. As one would expect, halving the GDP growth rate decreases revenue, impacting negatively on the broadcaster s net position, while increasing the rate to 6% improves their position. Costs are largely unaffected by the GDP growth rate, but do increase marginally as the GDP growth rate increases since levies are modelled as a proportion of revenue. Adoption is affected by the real GDP growth rate because household incomes increase by this rate. In Scenario 2, for example, decreasing the GDP growth to 2% results in roughly 60 000 more households falling below the affordability threshold in 2008 compared to the default rate of 4%. This will increase government subsidies to these households by approximately R150m. 5.4 Licensed Pay-TV Bouquets Pay-TV bouquets compete for advertising revenue and increasing the number of licensed bouquets impacts negatively on the incumbent broadcasters, as is evident in Table 4 below where the numbers in the top row represent the number of bouquets licensed in Scenario 1 (the magnitude of the impacts are similar for Scenario 2 and 3.) M-Net is more sensitive to the change in the number of pay TV bouquets since