The Incumbents' solution is in search of a problem

Deutsche Telekom, France Télécom, Telecom Italia and Telefónica (hereafter The Incumbents) have issued a report called ‘A Viable Future Model for the Internet’. It reflects their well known stance on the “they are using my pipes for free” case, but it also offers a thorough review of options for how the Internet could be financed. O, and it was published by A.T. Kearney (which I hope earned a little bit less than 25 million Ozzie dollars for this report). While being a thorough report and an interesting read, there are some passages that we have a problem with. For inquires you can try to mail to incumbents@kearney.com.

First of all, here are the ‘structural problems’ that are perceived by The Incumbents:

• ISPs (called Retail Connectivity Providers in the report) have not been able to monetize traffic growth. They are the victims of the very popular flat rate Internet. There is a disconnect between traffic growth and revenue growth. “… for growth to continue, the next few years must see a realignment of who captures the value and who funds investment in the Internet value chain” (page 1, a nice twist to Ed Whitacre’s above quote). It is also stated that “video traffic , much of it free to the end user” (page 1), while the end user pays a lot of money to his ISP.
• OTT providers (called Online Service Providers in the report), who hardly contribute to the cost of the network, are not incentivized to use the Internet efficiently.
• Network congestion is inevitable.

Second, the four possible remedies proposed:

1. Raise retail prices.
2. Introduce a data-conveyance charge for OTT providers.
3. Enhanced quality services over the public Internet.
4. Enhanced quality services based on bilateral agreements.

It becomes immediately clear from the above how The Incumbents position themselves in this issue. Fundamentally, they look upon OTT providers as publishers who have found an extremely cheap distribution platform, while The Incumbents pay for the networks. At the same time, OTT providers earn insane margins. The report also stands up for rights owners and speaks out against piracy, implicitly linking heavy usage to illegal file-sharing.

As the report discusses option #1, it finds an important objection against usage-based tariffs: “the problem is that end users often do not have full control or awareness of the actual traffic they are downloading. Software updates tend to download in the background automatically; animated adverts are not actively requested …” (page 26). This we agree with. Also, the writers think that price increases are not achievable, due to competition, and if they were, penetration and the uptake of new services could be negatively affected. This, we do not agree with.

As to option #2, the proposed charges are EUR 0.05 per GB for fixed and EUR 3.03 per GB for mobile networks. It is suggested that OTT providers could simply “… adjust their commercial models to cover the higher costs – doing so for example, with higher advertising fees or subscriptions ” (page 30). This is of course totally unrealistic: getting rid of the flat fee issue simply by pushing it to Google, saying that they should raise their rates. Check out Benoit’s post to see how this can’t work (or would they have their charges off by mistake by a factor of 10 or 100?).

Options 3 and 4 are about creating ‘Internet fast lanes’, or a ‘two-class Internet’, which has all sorts of net neutrality implications – which we do not need to replicate here.

Here are a few problems we have with the report:

• The report is based on the assumption that congestion is inevitable. However, despite incredible growth, congestion hasn’t really been an issue yet. In other words, the solutions provided are in search of a problem. As Telegeography shows us periodically, capacity investments are ongoing and often outpace traffic growth. Also, the report appears to be sloppy in many places about which part of the Internet it focuses on: is it the long haul, the middle mile, backhaul or the access network?
• A big deal is made out of using ‘the network’ efficiently, but if we are not mistaken, it becomes clear in just one place what this actually means: “Free video sites in general may find the conveyance charges are a strong incentive to develop more efficient traffic delivery (better compression techniques)”. So, one crucial and ‘structural problem’ is just about compression? Also, it seems entirely unconvincing that OTT providers would not care about compression.
• The report fails to show that the linear value chain (figure 3) needs repair. In fact, it has served the Internet very well, with traffic flowing from left to right and money in the other direction. We also wonder why the Sony or the Philips analogy is not addressed, which so neatly nails the problem with solution #2 (above). (It must be acknowledged that the nature of OTT service provision weakens the analogy, because in the electricity world, there is no analogue to the OTT provider.) One could say that it is The Incumbents’ good right to try making OTT providers pay, but it would be at odds with how the Internet is organized today. Further, they could use their market power to bully these charges onto OTT providers, but that would appear to be sheer abuse of market power.
• OTT providers (aggregators, not producers) pay a lot to distribute the content to servers all over the world.
• OTT providers are described as the ones generating traffic ('traffic senders'), completely ignoring the fact that it is the end user who is in fact requesting the traffic. Put differently, without OTT providers, nobody would need a broadband connection in the first place. The Incumbents owe their entire (very lucrative) broadband income stream to the OTT providers.
• Investors know that looking at margins alone doesn’t provide the whole picture. Some sectors are characterized by high margins, others by low margins. It depends on the nature of the business, which involves volumes as well.
• The Incumbents are ignoring a minor detail: risk. For the non-investors: risk has nothing to do with our everyday-life use of the word; in investment theory, risk is about the standard deviation of returns. Just that, nothing more. Now take a look at Apple’s revenue growth and compare that to the extremely stable revenue profile of network operators. Remember further that The Incumbents are vertically integrated, with completely different risk/return profiles for the different layers (passive, active, services). Which is why there is increasing focus among newcomers on just one of the layers. OTT providers are no exception, even though they (Google in particular) do have extensive network assets.
• If ISPs lack pricing power, sooner or later the market will sort this out. Many ISPs would be bound to go out of business. The fact that they don’t proves that broadband is still a high-margin (!) business. If ISPs complain about a disconnect between traffic growth and revenue growth, their natural response should be to raise prices, not turn around and look to the other end of the vale chain to extract money from.