Proposition Paper on Strategies for Sustainable Prosperity

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Submitted by CIRANO 2010–07–06 12:13:05 EDT
Theme(s): Building Digital Skills, Canada's Digital Content, Digital Infrastructure, Growing the ICT Industry, Innovation Using Digital Technologies

Summary

The country is ready and is in need to undergo change. Canada is ready to face the challenges and gain from the benefits of adopting a digital economy. The initiative of Minister Clement to pin point the issues that the Canadian government should tackle to ensure a well oiled digital economy is timely. As many members–countries of the OECD are preparing for the new telecom revolution, we should benefit from our know–how, our talent and our scientific expertise to deal with the digital challenges of tomorrow.

A recent study issued by CISCO projects a 40 times increase in broadband use between 2010 and 2014. The introduction of smartphones and laptops into the mobile network increases broadband demand for efficient spectrum availability and management, but also for cutting–edge technologies, and so, to sustain an increase in demand that will follow in the years to come as its use will gain in popularity.

The availability of a secure and efficient telecom infrastructure will affect and change many aspects of the economy. Our way of life and the way we use to perform many daily tasks in health, education, energy and business will give way to new culture and way of life.

However, the regulators should have a proactive approach to this project in order to ensure a proper response to social and economic needs. Thus this proposition paper highlights five critical elements that need to be dealt with to launch the digital era:

  1. Digital Capabilities and the Efficient Regulation of Competition in Broadband Telecommunications
  2. Talent Attraction and Retention in a Digital Economy
  3. Access Pricing in Digital Networks
  4. Research and Development in a Cutting–Edge Digital Industry
  5. Real Option Valuation of Investment in Digital Capabilities

Submission

1. DIGITAL CAPABILITIES AND THE EFFICIENT REGULATION OF COMPETITION IN BROADBAND TELECOMMUNICATIONS

Telecommunications and more generally digital or ICT technologies constitute the backbone of our societies. Nothing is more important for the well being, present and future, of modern societies than ensuring an efficient deployment of digital technologies and an efficient web of telecommunications chains and networks. Such deployment and web are essential for social cohesion, productivity gains, innovation and commercialization, and for reaching higher levels of humanist economic growth.

Digital capabilities (products, services, skills and talents, innovation and commercialization) and telecommunications chains and networks are complementary and superadditive: doing more of one increases the returns to doing more of the other. Their joint development is significantly influenced by the regulatory framework put in place to oversee the evolution of the telecommunication web towards efficiency. The Government's role is to implement policies aimed to protect efficient newcomers from predatory incumbents, to protect the public from the undue exercise of market power by large firms, and to protect owners of irreversible or sunk (network) investments from being held up once the network is in place. If and when the level of competition is deemed sufficient, specific economic regulation is expected to disappear in favour of general competition or antitrust policy, while technical, architectural or design regulation and coordination will subsist.

When is the level of competition in a national telecommunications industry sufficient? When it is not, when will it be, that is, what value of which indicators will tell us that the time has come? The answers to those questions are vital since too much economic regulation for too long as well as too little economic regulation for too short a time are likely to generate important social costs in terms of consumer welfare, productivity, innovation, and growth.

It is of the utmost importance for the deployment of digital capabilities in Canada that a new approach to regulation of broadband telecommunications be put in place to foster the efficient development and deployment of broadband networks and the efficient adoption rate and level of digital technologies with concurrent digital capabilities. What could such a regulatory approach look like?

The new regulatory framework should rest on four specific drivers of economic efficiency:

  • The pursuit of a dynamic regulatory approach based on implementing proper competition processes and information systems.
  • The promotion of competition through proper incentives ensuring:

    • Dynamically efficient inter–access prices and conditions
    • Efficient investment programmes in network maintenance and development
    • Direct incentive subsidies such as deferred investment credit to be paid at some time in the future conditional on the entrant's capture of a predetermined market share.
  • The design of non predatory pricing rules through full cost sharing to promote the emergence of a more competitive industry, even if such rules reduce static efficiency.

In such a regulatory framework, all potential entrants with superior products or services, and/or superior technology, and/or better quality consumer service, and only those, who believe they can compete with and displace the incumbent one way or another, will enter or consider entering the industry. A particular attention should be given to the capacity of newcomers to stimulate the development and adoption of digital technologies in business, government and society as a whole. Consumers and customers will reap the benefits of efficiency–enhancing competition through proper creative destruction.

2. TALENT ATTRACTION AND RETENTION IN A DIGITAL ECONOMY

Canada seems to have a growing problem in attracting, fostering and retaining talent. Nowhere is that more important than in digital technologies. The educational system (high schools and universities) doesn't produce enough specialized degrees to meet the industry demand, and the few who are qualified are hard to retain. The problem is made even more crucial with the aging of Canadian population.

A first and most important set of policies should be focused on improving the overall productivity of the economy, specifically through the encouragement of innovation and adoption of ICT applications. In fact Canada was able to increase its real GDP/worked hours by 41% from 1981 to 2008, but this number is amongst the lowest in the OECD countries where countries like Japan reached an increase of 95.6%, France of 77.9% and the UK 76.3%. All of these countries who do suffer from an aging population seemed to have better performance in productivity.

A second set of policies should be focused keeping the aging workforce active for a longer period of time. People should be induced to pursue their career for longer periods of time as long as they are able to fulfill their professional duties and contribute to the economy. People live longer, thus should be allowed to retire at a later age. For example, the possibility for people to receive a pension while remaining at their job should be considered.

Most importantly, we must allow for talent to be rewarded at its market value. The world is a village and it is relatively easy to migrate from a country to the other if the remuneration is more interesting. Talent should be regarded as a rare commodity thus needs to be remunerated at its market value, which reflects the need to rethink our income tax program. However monetary compensation isn't the only factor that could be rethought. A significant objective in strategic management is to find ways to increase firms' efficiency through better internal management of highly skilled employees. Industry Canada's role could be to encourage the industry to adopt new organizational behavior and HR policies that will implement organizational commitment and job satisfaction. This will help retaining valued employees that are hard to replace in technical and specialized telecom areas. So the question is to develop policies that would build work environment and social relationships to ensure commitment and satisfaction of employees in a digital economy.

As for the shortage of qualified software engineers and applied mathematicians, the solution could reside in reforms in the educational system. This might seem an ambitious project but with the right incentives and regulations, this could be attained. Since the problem resides in the lack of incentive to generate enough specialized professionals in the digital economy fields, we should encourage the educational institutions that are capable to form highly skilled workforce in these cutting edge technical fields. The solution might be through incentive based policies that would promise educational institutions a financial reward if they reached a predetermined benchmark for the number of graduates in the most needed fields. This would encourage educational institutions to better train students that have the capability to pursue scientific courses but aren't trying hard enough to enroll in more difficult programs (i.e. telecom engineering, software engineering, applied mathematics, etc.)

Following the 2009 recession, many companies have chosen to cut costs by allowing their employees to work from home. This initiative that was originally temporary has become increasingly popular when companies realized an increase in productivity of their employees. However some companies are still reluctant to follow since some type of confidential information treated within their offices should not be leaked. If appropriate security was provided on networks, this trend might allow for higher productivity, but will also encourage more individuals to participate in the active workforce. For instance, women who just gave birth or have young children and are reluctant to leave their toddles at the hands of day nurseries could now be encouraged to work from home with flexible hours. However securing these networks isn't the only concern, spectrum management should be improved in order to allow for higher demand of spectrum use. People working from home should be provided with the sufficient broadband services to communicate with their colleagues from a distance.

3. ACCESS PRICING IN DIGITAL NETWORKS

Electricity transmission, natural gas transportation, railway tracks, and telecommunication services, are amongst industries where the final product typically requires access to essential segments or nodes of the network, and are generally referred to as essential facilities.1 Some firms possess and control the supply of one or more inputs that are vital for competitors. To increase economic efficiency, regulators across different jurisdictions spend significant amount of resources aiming to select, design, and implement proper access pricing rules, prices and conditions to allow competitors to have access to essential links of proprietary networks.

If a network owner is also a supplier of final products and services, it may have an incentive to overcharge the competing companies, not only to enhance revenue, but also to increase the competitors' cost and thus to effectively block or reduce entry.

Extra care must be taken in formulating the rules, as a failure to select the appropriate pricing rule might result in suboptimal gains. When the price is too low, the incumbent firms have lesser incentives for investment and innovation. It is equivalent to providing undue subsidies to entrants, encouraging inefficient entry and reducing social welfare due to insufficient future supply of network capacity. When the price is too high, efficient entrants are discouraged from entering, which in turn causes competition to be less intense than optimal. Competitors may have incentives to inefficiently bypass incumbents' facilities. So, what is a reasonable access price?

Several "classical" access pricing rules have been proposed [Efficient Component Pricing Rule (ECPR), Ramsey Pricing Rule, Global Price Cap, and Cost–Based Pricing Rule]. All those are rules with a short term view, designed to maximize social benefits in a static sense. It is imperative to develop a rule within a proper dynamic efficiency framework. We intend to develop the Real Option Access Rule, under which it will be in network owners' best interest to let efficient firms have access to essential network segments, even if this means bringing in extra competition into an oligopolistic environment.

The access price set under the above "classical" access pricing rules does not adequately compensate network owners for the risks undertaken in irreversible investments under uncertainty. Economic analysis of irreversible investment under uncertainty implies that returns must be well above the "breakeven" level of Risk–Adjusted Return on Capital under Net Present Value. Under uncertainty and irreversibility, network owners' incentives to develop and maintain their networks are sub optimal, thereby favouring under–investment or undesirable delays in investment plans. These impacts decrease future social welfare.

To ensure an efficient development and penetration of digital technologies, products and services, it is essential that proper Real Option Access Rules be developed and implemented, under which both network owners and competitors in final products and services will feel properly treated on a level playing field.

4. RESEARCH AND DEVELOPMENT FOR A CUTTING–EDGE DIGITAL INDUSTRY

Spending on Research and Development (R&D) in Canada varies widely amongst provinces. While Quebec's expenses in internal R&D as a percentage of its real GDP is amongst the highest in many OECD countries (2.70%), the overall Canadian level is amongst the lowest and only reaches 1.98% of real GDP. As for business expenditures on R&D as a percentage of the real GDP, Quebec with 1.63% is still ahead of the Rest Of Canada (ROC) with 0.98% but Canada as a whole is behind many OECD countries at 1.06%. Nevertheless, Québec is lagging behind the rest of Canada both in terms of GDP growth and of job creation.

Canada lags in R&D but what hurts its economic growth is essentially the inability of the R&D to be reflected in profitable commercialization. Minister Clements has acknowledged the need to build efficient bridges between academic research entities and industry to ideally form a symbiotic relationship. In order to do that, additional efforts should be made to encourage such collaboration specifically in the field of telecommunications. Research institutions should not only be encouraged to publish in academic journals but also in practitioners' journals to give more exposure to their findings. But mostly, the government should create incentives to both the academic and the private sector to collaborate more. This could be done through new incentive–based subsidy plans for engineering schools, high tech firms and telecom services providers. There is however no simple solution to increasing innovation. Since the performance of a digital economy is as good as the quality of its skilled workforce in generating and processing the proper information on current best technologies and further ones, Canadian institutions should ensure the needed engineers and provide a challenging work environment that would commit them to their jobs.

On the other hand, while subsidizing research and development can play a key role in the advancement of invention and innovation in Canada, there is an urge to rethink the way they are allocated. The current subsidy system is suffering. Companies become dependent on them to finance their regular activities leaving little money to effective research. In addition to that, companies are too protected by the government which discourages them from taking risk when the government isn't by their side. Canada's social protection model is a great asset but too much protection has proven to reduce responsibility and incentives. Companies increasingly rely on subsidies which diminish their entrepreneurial incentives to take risk and expand faster. Many believe that firms' struggle to develop, design and commercialize leading edge technologies, products and services derive from the business environment they are facing.

The subsidy allocation system must stop pouring money into unproductive projects. The system should be redesigned in order to be more incentive–based. One possibility that should be evaluated is the following: provide generous investment credit, income tax credit or other form of incentives based on the ex post success of the commercialization of inventions and innovations. All candidates to subsidies on R&D with possible and potential superior products or services, and/or superior technology, and/or better quality consumer service, and only those, who believe they can compete with and displace incumbent products or technologies one way or another, will enter or consider entering the industry. Inefficient competitors, fly–by–night operators and fast–buck seekers will stay out. Consumers and customers will reap the benefits of efficiency–enhancing competition through proper creative destruction.

The adoption of ex post incentives does not in itself guarantee an efficient outcome, but it can help to encourage entry by firms with the proper mix of competitiveness and efficiency to enter the subsidy competition. With this in mind, ex post incentives are most compatible with stated digital policy, fostering a competitive marketplace that enhances the welfare of Canadians. The effects are non–distortive and will not create undue welfare costs brought by inefficient firms entering the race, as would likely happen with an ex ante subsidy.

5. REAL OPTION VALUATION OF INVESTMENTS IN DIGITAL CAPABILITIES

It is well known that Canadian businesses and individuals invest less than most of their counterparties in other OECD countries in digital capabilities (digital technologies, competencies, products and services). One reason may be the lower level of management and decision making skills regarding investments in new technologies and new business models. The concrete manifestation of this alleged inferior set of skills is that Canadian managers' approach to decision making under uncertainty and irreversibility (cost of backtracking) gives too little attention to the value of options that these investments in new technologies and new business models provide.

The real options approach considers strategic management and decision–making as a process aimed at proactively reducing exposition to downside risk and promoting exposition to upside opportunities. It stands at the hinge between pure finance and other areas of decision making under risk such as project evaluation, market entry and exit, organizational restructuring and re–engineering, technology adoption, etc.

The approach underlines a frame of mind and uses methodologies that appeal to a wide array of managers, thus providing a common language. Real options have applications in many areas that are central to modern corporations: market coverage and development, finance, human resources management, technology management, R&D and knowledge management, and in particular investment in digital capabilities (technology, business model, product and services, human resources management, R&D, etc.). As the real options approach percolates into various areas of management and decision making, there is a shift of emphasis from pure evaluation to decision analysis and optimization. The specific most important contribution of higher level managers to the value of a firm may fundamentally lie in the creation and exercise of real options.

Considering a real investment project, such as building a plant, adopting a technology, implementing a restructuring plan, entering a new market, launching R&D projects, developing digital capabilities) is similar to holding a financial call option. A real investment project involves the option, but not the obligation, to spend resources at some future time in order to develop, pursue or change some business strategies whose value is typically uncertain (stochastic). As time goes by, new information becomes available which can be profitably exploited if previous decisions or investments have been made or undertaken and if the managing team has the flexibility to act upon this new information. This is the essence of the real option management compound: investments give rise to real options whose exercise requires knowledge and flexibility, hence competencies in defining, designing and managing those options. At the time the original investment is made, management must be able to value today those future options which may arise.

In the context of investments in digital capabilities, the real options such investments may contain are likely to represent a significant value which must be recognized by management. If management relies on traditional valuation methodologies such as net present value, internal rate of return and payback period, which cannot properly determine the current value of those options, then it is predictable that investment in digital capabilities will be suboptimal, possibly by a significant margin.

The Canadian digital strategy should contain a commitment to develop those real option valuation tools whose absence or ignorance may directly affect the development of digital capabilities.


1 For example, under Canadian legislation, access to a network is typically required as a critical input by competitors to provide services in a relevant downstream market; the network is usually controlled by a firm that possesses upstream market power such that withdrawing mandated access to the facility would likely result in a substantial lessening of competition in the relevant downstream market; and last but not least, it is not practical nor feasible for competitors to duplicate the functionality of the facility.

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