September 24, 2015 11:10 AM

ILEC Special Access: Is It a "Relevant Market?"

I was troubled to see the FCC, in its Technology Transitions Order, tell ILECs that they would not get the full benefit of their new fiber deployments until the Commission concludes its "review" of competition in the "special access market."  Order, paras. 101-143. Then, last Thursday, the FCC announced that it had taken a "major step" in its review of competition in the special access "market" by making its collected data available to the parties.  And, that made me feel a lot better.  (just kidding!)

The FCC should be moving forward with its review, if only because it's been 14 years since AT&T first petitioned the FCC to revisit its 1999 Pricing Flexibility Rules.  However, the fact that the FCC has not, more recently, focused on the threshold question of whether ILEC special access service is even a distinct "relevant market" should give the public doubts about how quickly this matter will conclude.

You see, the FCC can never justify economic regulation for the benefit of "consumers" if the regulation does not apply throughout the entirety of a rationally-defined market.  For example, last September, Chairman Wheeler explained in a speech that he believed cable to be dominant over the most important part of the consumer broadband market (25Mbps and above), yet the FCC's Open Internet rules applied much more broadly.  Likewise, the last time the FCC made rules affecting ILEC special access, point-to-point data transmission was only widely available from the ILEC.

As a rational matter, unless the Commission's rules cover (at least the majority of) an entire relevant market, its rules cannot possibly provide benefits to consumers in that market.  Here's why it's doubtful that "ILEC special access" services constitute a relevant product market in most parts of the country.   
It's Not a Market If Similarly-Situated Customers Don't Use It

Several years ago, the FCC had a "forum" on special access, and you know what?  Everyone was old!  And, so are the companies and carriers that buy a lot of ILEC special access.  The next time you see a story about special access, look at the age of the companies complaining.  I guarantee you that they all started before 2000.

Why aren't there any "young" companies complaining about special access?  Well, probably for the same reason there's no young Bingo players:  it's not that fun, and younger gamblers had better alternatives when they picked up the habit.

bingo lady1.jpg
switchboard operator1.jpgBandwidth Intensive Customers Don't Need ILEC Special Access.  If this isn't obvious, just look at the blog where I explained why Google (and other content delivery companies) took Netflix's "interconnection service" candy at the 11th hour of the net neutrality proceeding.  Netflix was trying to obtain--through regulatory pan-handling--the same benefits that these companies had invested so much capital to create through their own networks. 

The appendix at the end of the blog shows network investment by companies that were new enough to not need special access, but yet old enough to have purchased high-bandwidth transmission capacity at "rock bottom" prices in the wake of the 2002 telecom meltdown.  These companies would never have invested that kind of money to build their own networks if they were destined to be dependent on ILEC special access.

Small/Medium Retail Customers Have Non-Special-Access Competitive Alternatives.
One might argue that it's unfair to just look at the most bandwidth-intensive customers, because CLECs often rely on special access to serve fairly small (in terms of number of locations) business customers.  I couldn't agree more.  That's why it was interesting that just last week, Comcast Business Services announced that they are able to serve multi-location business customers throughout the country through wholesale agreements they have struck with other large regional incumbent cable companies.   

While Comcast's announcement focused on the fact that it could now (with out-of-region wholesale agreements) serve large national multi-location customers, the more interesting point was that it's in-region business unit (small/medium customers) has been the fastest growing part of its business for the last several years.  Similarly, the success of "bring your own access," web-based business providers, like RingCentral and ShoreTel is further testament to the fact that small and medium business customers generally do have choices for competitive phone service--regardless of whether the customer's existing CLEC provider can use these substitutes as wholesale inputs for their retail service.

The bottom line is that it's not a "market" if not everyone needs it--then it's just a brand.  But, even old customers of old brands can find it in themselves to switch brands . . .  

It's Not a Market If There Are Substitutes

You know what's interesting if you compare who filed comments in this proceeding 10 years ago with the companies that are still active now?  It's who's missing.  Any guesses?  Hint: what's different between these two?

John_Legere1.jpgchristopher_walken1.jpgNo matter what your lyin' eyes are telling you, these are not a "before and after" picture of the same guy.  One is T-Mobile Chairman John Legere (before he became a hippie), and the other is John Legere look-alike Christopher Walken.  

When the FCC kicked off its special access review, in 2005, T-Mobile filed essentially the same special access comments as Sprint.  But, after the introduction of the iPhone in 2007, it became clear (to everyone not named Sprint) that mobile data was the future of wireless, and bandwidth constrained cell-sites would not satisfy, or attract, customers for long.

Hence, T-Mobile took its first major step in quitting special access in the Fall of 2008, when it named 6 new vendors of advanced fiber backhaul solutions.  By February of 2010, it was reported that T-Mobile had replaced copper backhaul with fiber in 7% of its towers, with plans to raise that number to 25% of its towers by the end of 2010.  Finally, in August of 2012, T-Mobile announced that it had upgraded all of its cell sites to advanced backhaul services, 95% of which were served by fiber.

The T-Mobile example is indeed dramatic.  But, just as T-Mobile switched tens of thousands of locations to fiber, there are other successful wireless competitors that entered the market after T-Mobile, like Cricket and Metro PCS (acquired by AT&T and T-Mobile, respectively), that never used ILEC special access (or at least never complained about it to the FCC).

*    *    *

Some CLECs have pointed out that there are always going to be some significant number of buildings that will only be accessible via ILEC facilities. But, this fact does not make those locations a "market,"  because, there is no evidence that the ILECs price services to these locations any differently than they do for the bulk of their customers that do have access to competitive alternatives. 

Thus, the FCC cannot rationally conclude that there is a separate "market" for a subset of an ILEC's customers (that the ILEC does not treat differently) for a service that not all of the ILEC's competitors, or retail customers, need to use.  And this is why this proceeding will not conclude anytime soon.

May 29, 2015 2:20 PM

The Historical Evidence Supporting the ISP Discrimination Theory

The primary justification for "strong" net neutrality rules is always that there is insufficient competition in the infrastructure services market.  The theory that insufficient competition in an Internet access market enhances the ISP's incentives/ability to discriminate against "off-net" traffic sources (content, applications, or interconnection facilities of smaller rivals) is a foundational premise of the Commission's recent Net Neutrality/Broadband Reclassification Order

Today, we're going to look at the origins of this theory--in competition law--and whether there is any historical evidence to validate this concern.  This may seem risky, because if historical evidence isn't conclusive, it can be claimed as "support" for a lot of different theories. 

giorgio-wheeler meme3.png         
For example, "ancient astronaut theorists" (as the History Channel calls the UFO crowd) point to surprisingly-advanced ancient wonders throughout the world (e.g., pyramids, or other very large inland structures) as "evidence" that aliens were responsible for these accomplishments.  While some [non-History-Channel-viewers] will be inclined to dismiss ancient astronaut theories, these theories cannot be disproved, either.  On the other hand, if the historical evidence is conclusive, it can rule out inconsistent theories.  Is "ISP market share=interconnection degradation" theory at least as viable as ancient astronaut theories?

WorldCom "Will . . . Become the Internet"

The quote above was from an antitrust complaint, filed by one of WorldCom's smaller rivals in the Internet backbone market, in 1998.  GTE Complaint at ¶2.a.  (emphasis in original)  The smaller rival was no beginner, it was GTE--the country's largest integrated local/long-distance telephone company (at a time when virtually all Internet traffic was carried on telephone company facilities). 

Moreover, GTE wasn't crazy to be concerned.  If you had a crystal ball, you could not have positioned yourself better than WorldCom did through a series of acquisitions from '94-'96, which--you may recall--was when the commercial Internet took shape.  By the end of 1997, WorldCom was the largest provider of Internet backbone capacity in the country. 

So, when WorldCom sought to acquire the second largest Internet backbone--MCI--in November 1997, the DoJ was concerned that the post-merger firm would control between 40-70% of the Internet backbone market.  In early 1998, the Economic Policy Institute estimated that 62% of the entire Internet's revenue would need to traverse the MCI WorldCom backbone, and 50% of all ISPs would be dependent on access to the firm's backbone network. 

A Flawed Theory Takes Root

GTE believed so strongly that the MCI-WorldCom merger threatened its ability to compete in both the Internet backbone, and long-distance, markets that it filed its own private antitrust suit to enjoin the MCI-WorldCom merger in May 1998.  In GTE's Complaint, the company explains its concerns:

all of the major backbones . . . are . . . dependent upon each other for interconnection. They thus find it in their independent interests to cooperate to maintain and upgrade the capacity of interconnection among their networks in order to offer their customers ubiquitous, high-quality access to the whole Internet. . . .  By concentrating . . . the two largest Internet backbone networks to create one dominant national network, the merger will give MCI-WorldCom a stranglehold over the burgeoning Internet and the incentive and ability to stifle competition from all other rival Internet backbone operators, including GTE.
GTE Complaint, at ¶2.a.  Interested readers should look at GTE's full Complaint, as (I promise) you'll find it all sounds very familiar. 

GTE's case never made it to trial, because the facts of the Complaint would soon become less clear.  In July of 1998, MCI agreed to spin off its own Internet backbone to Cable and Wireless; after which the DoJ cleared WorldCom's pending acquisition of MCI with a press release.  The FCC issued its Order clearing the transaction soon after the DoJ's Press Release. 

"So Much for Grand Efforts by Regulators to Dictate Outcomes"

MCI's divestiture of its Internet backbone didn't work out as the DoJ and FCC had hoped.  There were soon allegations that MCI had "pulled a fast one," and had not provided C&W much more than the physical assets of its Internet backbone business.  C&W sued MCI WorldCom in March of 1999. 

Undeterred, WorldCom announced it was buying Sprint for $115B in October of the same year.  In November of 1999, C&W aired its grievances at a Congressional Hearing on the Sprint/WCOM merger.  A little over a month later, Carleen Hawn wrote an incredibly insightful short piece for Forbes, entitled "Swimming with Sharks."   

In her article, Ms. Hawn recounts C&W's complaints, but notes significant industry disagreement about which side was to blame.  According to Jim Crowe, founder of Level 3, the divestiture would never have worked as expected by DoJ, because C&W lacked a domestic U.S. network with which to interconnect the MCI backbone network.  C&W would, therefore, have had to purchase domestic Internet transit capacity.  (Note: this would have been right before Internet transit prices began a swift, steep, and inexorable, period of decline.  See, Dr. Peering table of Internet transit prices.)  

Thus, post-merger MCI WorldCom's market position was unaffected by the divestiture, as its share of the backbone market continued to grow faster than rivals.  In January 2000, Hawn states, "MCI WorldCom is simply more dominant than ever," concluding, "so much for grand efforts by regulators to dictate outcomes."  

A Dominant Gatekeeper . . . Isn't Abusive?

But, if the MCI backbone divestiture did nothing to diminish MCI WorldCom's dominance in the Internet backbone market, what was the outcome?  If GTE's theory was correct, MCI WorldCom would now have "both the incentive and the ability to act opportunistically to degrade the quality of interconnection and increase costs for its rivals."  GTE Complaint ¶23. 

Apparently, though, even with 60% of the revenue-generating traffic on the Internet being dependent on its network, MCI WorldCom never found it profitable to act on its incentives/ability to degrade rivals' interconnection terms.  Indeed, there's no evidence they--or any other ISP (either with respect to access or backbone transit)--has ever acted on such an incentive.  But it would take more than a decade for a court to make this finding.  

The Theory Goes to Court

There are two lasting legacies of GTE's theory of dominant ISP discrimination: 1) the general justification for the FCC's current Net Neutrality/Broadband Reclassification Order, and 2) Cogent's peering strategy.  Beginning with its very first ISP peering dispute, with AOL in 2002, Cogent has been the torch-bearer for GTE's never-tested (at the time) theory.  In fact, Cogent has wheeled out this argument every time it's been de-peered (which is a lot--partial list here), and most of the time it files something new at the FCC, or speaks to the press.

So, it was only a matter of time before Cogent tried to really test the GTE theory in an adjudicatory proceeding.  In 2011, Cogent filed a complaint with the French competition authority, alleging, among other things, that France Telecom's peering ratio (of 2.5X) constituted anticompetitive discrimination, as was France Telecom's refusal to unilaterally add capacity in violation of the firm's prior peering agreement.  Customers of France Telecom experienced congestion when downloading content from Cogent client, Megaupload

In many ways the French competition authority was the most sympathetic forum for this claim.  European competition law--with respect to dominant firm behavior--gives much more weight to preserving opportunities for smaller, and mid-size, firms (U.S. antitrust laws tend to focus primarily on economic efficiency).  See here at pp. 5-6/16.  French competition law is more favorable (than E.U. law) to smaller firms versus dominant rivals, and includes the notion of "abuse of a situation of economic dependence."     

But, Cogent could not make the theory overcome its facts; real-life ISPs simply don't discriminate as predicted.  The French competition authority ruled against Cogent.  See summary here.  Cogent appealed the decision, and a French appellate court affirmed, noting that peering was not an "essential facility," and is in no way functionally different from, or inferior to, transit.  See summary here.    

It Costs More $$ to Believe a Theory than Our Own Lyin' Eyes

In May of 1998, the commercial Internet had only been around for a few years.  At the time, GTE's concern that a "dominant" firm would abuse its position to degrade access to, and raise prices of, interconnection facilities needed by its smaller rivals was not an unreasonable concern. 

However, GTE's concern was immediately put to the test in actual market conditions, and it proved inaccurate.  More recently, as noted, Cogent failed to convince a regulator, under the most lenient standards, that it was harmed by the dominant firm's observance of international peering standards.  A French appellate court agreed, and confirmed this finding.

giorgio_my meme2.png
Yet the "dominant ISPs will harm consumers/competitors" theory--unlike the ancient astronaut theories--continues to pick up traction from sources that should be more skeptical.  But, unlike the ancient astronaut theories, continued belief in the GTE theory is not harmless.  Last week, in a policy memo, Hal Singer of the Progressive Policy Institute describes some of the many costs--in terms of services and innovations foreclosed, and investments forgone--of continuing to believe in the possibility of a theory that our "own lyin' eyes" have never seen happen.

May 22, 2015 3:23 PM

The FCC Should Not Use the AT&T-DirecTV Merger to Weaken Internet Interconnection

Over a year ago, I explained why the Comcast-TWC merger may present regulators with concerns.  On the other hand, I also explained that the AT&T-DirecTV merger presented consumers with nothing but opportunities.  As noted earlier this week, those opportunities have only expanded with ISP/MVPD competition and increased pressure on the programming bundle.  The post-merger AT&T-DirecTV would be a tempting target that may well give some programmers an incentive to "cheat" the industry-standard distribution agreements, and finally let go of the Bundle.

But, recently, news reports have said the FCC may require AT&T to accept "interconnection conditions" as a prerequisite to granting its approval to AT&T's acquisition of DirecTV.  This would be a mistake, because it would also undermine the careful restraint the Commission showed in its (still overly-broad-for-the-purpose) Open Internet Order

In a general sense, all regulations distort economic incentives; and overly broad regulations create more profoundly-distorted incentives.  Still, the FCC did show some restraint--with respect to Internet interconnection--in its ultimate Order.  The Commission should decline invitations to undo its previous well-considered reservations, as it will only promote moral hazard and careless network practices by those it has been asked to "help." 

Regulations Shouldn't Distort Market Discipline--Lessons from the Mortgage Crisis

Overly-broad regulations--designed to minimize one market risk--can easily distort incentives in adjacent markets (or market participants) in ways that create worse problems than the one the regulation was supposed to address.  This was the message of Charles Plosser, the President and CEO of the Federal Reserve Bank of Philadelphia, as he reflected on the role of prior government regulations in contributing to the mortgage crisis.   

In a speech entitled, "Responding to Economic Crises:  Good Intentions, Bad Incentives, and Ugly Results," Plosser considers why we continue to see financial crises, despite the fact that each crisis inevitably brings its own new regulations.  He concludes that, it's "[b]ecause the public and our lawmakers seldom recognize that attempts to insure against bad economic outcomes can sometimes be counterproductive."

Plosser (quoting economist Allan Meltzer) says, "Capitalism without failure is like religion without sin. It doesn't work."  He explains that regulations cannot insure "all manner" of market participants against bad outcomes (or limit the ability of firms to take risks); because while such rules might reduce market volatility, they would also limit innovation and economic growth. 

Plosser offers a number of examples where regulations undermined market discipline, making the overall system more vulnerable.  For example, in the decades preceding the crisis, the government provided numerous implicit and explicit subsidies to financial firms (Fannie/Freddie) and others that became "too big to fail."  By limiting these firm's risk, the subsidies gave lenders the impression that the government would always bail these firms out.  Thus, those lending the money to these firms had little incentive to limit the amount of debt they allowed the firms to accept.   

Plosser concludes that better regulations, and not simply more regulations, are the proper response to market failures.  He cautions,

If regulation distorts incentives, it can create moral hazard problems whereby firms don't bear the costs they impose on others. Such regulations can have unintended consequences that interfere with achieving the regulations' goals. 

The Commission's Invitation to Create Moral Hazard

Of course, there aren't perfect parallels between the financial system and the Internet, but there are enough similarities to draw some useful lessons.  The financial markets function best when they keep money flowing to efficient uses from efficient sources.  Similarly, the Internet, especially the market for Internet interconnection, has become the world's most efficient system for the routing and delivery of data traffic. 

As we have explained previously (see, here and here), the market for Internet interconnection works well, and has its own market discipline, which serves consumers well.  Where the financial markets efficiently reward accurate risk evaluation, the market for Internet interconnection rewards those firms that invest in the most efficient networks to provide valuable traffic routing to prospective interconnection partners. 

Thus, the FCC wisely decided not to regulate Internet interconnection as a separate "service," despite being heavily lobbied to do so by a tiny minority of firms."  In its recent Open Internet Order, the Commission, also wisely, declined to impose any specific interconnection obligations on ISPs, choosing to "rely on the regulatory backstop prohibiting common carriers from engaging in unjust and unreasonable practices." Order ¶ 203.

Recent events have vindicated the Commission's restraint.  Some of the same firms requesting regulation have, indeed, been able to reach fair terms with large ISPs.  Level 3 and Comcast, as well as Cogent and Verizon, have recently been able to reach mutually-beneficial, long-term agreements. 

Unfortunately, though, a few parties, including one (Cogent) that has had found itself on the "disciplined" end of  Interconnection market discipline more than any other (see, e.g., problems with Level 3, Sprint, generally, going back to AOL as a dial-up ISP), and another best known for recently gaming the Commission's own competitive bidding system, have asked the FCC to supplant competitive market discipline with extraordinary relief in the form of conditions to an otherwise pro-competitive merger.  These parties have nothing to lose by asking for relief

However, if the FCC accedes to these demands, AT&T's broadband Internet consumers can only lose.  Because, notwithstanding any evidence that AT&T is acting unjustly or unreasonably with respect to Cogent or Dish, these firms are asking the Commission to impose different terms on AT&T than other ISPs.  It is, therefore, more than likely that the FCC--if it agreed to do so--would be imposing a weaker link (through non-competitive interconnection terms) into some retail customers' supply chain.  This is no way to ensure consumers have the best end-to-end broadband Internet access.  It will, however, ensure that the FCC gets more requests to regulate outcomes best decided by a more efficient market. 

May 20, 2015 6:01 PM

Bundle This! Broadband ISPs v. Big Media Content

Recently, we showed how the broadband market is more competitive than the FCC wants to admit, and we've explained why the Big Media companies have a much greater profit incentive (than ISPs) to see the continuation of the (largely artificial) separation of content delivery into two businesses (subscription TV and broadband Internet access).  But, the fact is that broadband Internet access does compete with pay-TV video; the FCC's just wrong about whose side ISPs are on.

Channel Bundling:  Consumers (and ISPs/MVPDs) Hate It

Nielsen reports that consumers are buying more channels than ever, yet watch the same number that they always have.  The reason: big content companies require MVPDs to buy, and resell, all their channels ("the Bundle") in order to get the few channels that their customers want.  The Bundle is so important to media companies that they all use the same restrictive distribution contracts to protect it.  

Buzzfeed collected an excellent compendium of quotes about the Bundle late last year.  If you click on the article, you'll see that the only ISP/MVPD defending the Bundle was Comcast (who also produces a significant amount of content).  Consumers--and their retailers, MVPDs/ISPs--don't like the Bundle.

Cablevision v. Viacom

In 2013, Cablevision filed an antitrust case against Viacom over Viacom's requirement that Cablevision buy, and carry, a package of its least-watched channels in order to be able to buy any of its most-watched channels. See Cablevision statement and Complaint (redacted version).   Cablevision's antitrust claim is that the companies' 2012 distribution contract is an illegal tying agreement under Section 1 of the Sherman Act.  

Cablevision says that, in order to get access to the 8 Viacom channels it needs to be able to offer, Viacom requires it to purchase (and carry) 14 other channels that Cablevision's customers don't want.  The "standalone" price of the 8 channels Cablevision wanted to buy was set high enough to subsume Cablevision's entire programming budget; thus, it's only option was to buy all 22 channels. Complaint ¶ 8, ¶ 28.  

Cablevision argues that the capacity it must dedicate to the 14 channels it does not want prevent it from competitively differentiating itself by purchasing better content from Viacom's competitors.  As Cablevision explains, its channel capacity is finite;

Cablevision can devote only a portion of its available capacity to channels because Cablevision also offers other bandwidth intensive services (including high-speed Internet access). Cablevision would not reallocate bandwidth from these other services, which consumers increasingly demand, to carry more channels.

Complaint ¶ 27.
Tying agreements are "per se" illegal under the antitrust laws.  This means that a plaintiff does not have to demonstrate that the agreement actually had the effect of reducing competition in any market.  Instead, the plaintiff need only demonstrate the existence of the agreement, that plaintiff was economically "coerced" to buy the tied product, and that it suffered damages as a result. 

Accordingly, last June, a federal district court in Manhattan denied Viacom's motion to dismiss, finding that Cablevision had sufficiently plead a plausible violation of the antitrust laws.  Cablevision's claim has moved on to discovery, but its ultimate success is far from guaranteed.  However, regardless of Cablevision's ultimate success, it would be a mistake to assume that the converse claim--if Viacom were seeking strict enforcement of all contractual provisions--would be any easier to prove.   

Verizon's Skinny Bundles 

Perhaps this was Verizon's insight, when it announced its new "Custom TV" offers last month, allowing customers to choose their own "customized" channel package that includes more channels they want, and less of those they do not want.  For the basic price, Verizon's Custom TV customers get a general selection of popular cable news/entertainment channels, and can choose 2 (out of 7) channel groupings ("skinny bundles"), organized by topic/genre.  Customers can add other skinny bundles for $10/bundle/month. 

The reaction from the content owners was predictably swift, and angry.  Disney, Fox, and NBC were quick to condemn what they perceived as Verizon's reckless disregard for the Bundle.  Disney quickly sued Verizon for breach of contract. 

Is Verizon Breaching It's Contracts?

Verizon has said repeatedly that it is not breaking its contracts with programmers.  Therefore, we have to believe that Verizon is buying all the channels for all the customers it is required to pay for; even if that means every customer.  This seems likely, because, while the Custom TV promotion may "break the Bundle," some say it won't save you a bundle. 

Other MVPDs have also said that Verizon may be within its rights under the contracts.  Cox Communications told Fierce Cable that its agreements typically require the MVPD to buy and deliver channels to 85% of MVPD customers.  If the bundles are as valuable to consumers as Disney seems to think, then it's possible that 85% of Verizon's customers are buying ESPN.  Still, Disney isn't betting on it.

Will a Court Enforce the Bundle?

The news reports  have said that Disney is suing Verizon for breach of contract, and is seeking money damages and an injunction.  I haven't seen Disney's complaint (a public version has not yet been filed), but I'm guessing that the injunction would be to prevent Verizon from continuing to sell channel packages that don't conform to the parties' contract. 

If Disney is really dead set on preserving the Bundle, or preventing a jailbreak among its distributors, it's going to have to convince a court to order Verizon to 1) transmit content to at least some customers who have said they don't want it, and/or 2) limit customers' ability to decline unwanted content.  This is a real longshot. 

Courts are very reluctant to award specific performance if money damages will adequately compensate the aggrieved party.  Furthermore, courts are reluctant to grant any remedy that would result in "economic waste."  If I'm right about the relief Disney wants, it might as well have listed "economic waste" in its prayer for relief.   

If Verizon has breached its contracts with Disney, Disney will get money damages for any measurable loss it has suffered.  But, an important part of the Bundle is the deadweight loss that channel bundling imposes on MVPDs, and their subscribers, and the protection from competition that it affords programmers. Unless a court finds it worth rescuing, this part of the Bundle may well be gone; and that's a good thing.   

*     *     *

Every time a piece of the Bundle breaks off, consumers benefit and programmers get closer to having to compete on price as well as quality.  The fact that Cablevision and Verizon have been motivated to take up for consumers--and take on the Bundle--is another example of the competitive performance of the broadband Internet market.  Still, it's a good thing the FCC was spent the same time drafting more pervasive regulations for ISPs--so they wouldn't favor the Bundle . . . just in case? 
May 19, 2015 12:33 PM

Who Profits from Keeping Your Favorite Content Off the Internet?

In the last post, we discussed how the broad new regulatory framework that the FCC's Net Neutrality/Broadband Reclassification Order imposes on ISPs is predicated on a few, demonstrably erroneous, presumptions about the incentives of broadband ISPs.  Contrary to the FCC's assumptions, the evidence demonstrates that broadband ISPs have a powerful economic incentive to efficiently increase output of their most profitable product--broadband Internet access.   

But, incentives--and their impact on how consumers receive content today, vs how consumers would like to receive that same content--could use some further fleshing out.  After all, if someone didn't have an incentive to keep your favorite content off the Internet--you wouldn't be paying the same company two fat bills--for TV and broadband Internet--every month, would you?

Internet Consumers Love Content, and ISPs [Don't] Love to Sell It

While consumers love the high quality content that broadband providers offer through their MVPD service, TV distribution is not a profitable service for many broadband ISPs and is not the most profitable service for any broadband ISP.  See, e.g., this recent AP article, citing SNL Kagan figures, that cable companies earn 60% cash flow margins on broadband service vs. 17% on video service.   

But, even though most wireline ISPs would rather not be in the pay-TV business, there is a strong correlation between consumers that purchase pay-TV service and those that purchase broadband Internet service.  In the AP article cited above, Comcast says that about 70% of its video customers also purchase broadband Internet service.  For non-incumbent cable companies, the correlation may be much higher.  See, e.g., Randall Stephenson, Statement to House Judiciary Committee, June 24 2014, at 3 (More than 97% of AT&T's video customers also purchase another AT&T service.)  The fact is that broadband ISPs believe they must offer pay-TV service in order to compete for the best broadband Internet customers. 

Big Content Loves Consumers' $$ . . . Just Not Consumers

As noted in the last post, the big content companies do not seem to be as responsive to consumer demand as broadband ISPs.  In fact, companies like CBS, Comcast, Disney, Fox, Time Warner, Viacom, and various cable/satellite-owned regional sports networks generally don't make their "linear" (sports, news, and primetime) programming available online at any price, unless the customer is also a TV subscriber.  

And, it's not cheap to be a TV subscriber.  In its most recent Video Competition Report the FCC notes that, in 2012-2013, the price of the most popular tier of channels increased at a rate 3x the rate of inflation for the same year. 16th Annual Video Competition Report, table 5.  (5.1% vs. 1.7% inflation)  Comcast recently disclosed that its programming costs increased by almost 7.8% in the past year--almost 10x the inflation rate!  According to Nielsen, consumers now purchase an average of 189 channels per month, but watch only 17.

The FCC [Still] Doesn't Understand that Incentives = Profit

It's clear that, despite the evidence, the FCC still believes that, for most ISPs, it's more profitable to distribute programming for "Big Content" than it is to produce and deliver their own broadband Internet access service.  That's the only explanation for why Chairman Wheeler would offer this counsel to ISP/MVPDs at NCTA's recent INTX show:  

History proves that absent competition a predominant position in the market such as yours creates economic incentives to use that market power to protect your traditional business in a way that is ultimately harmful to consumers. . . . Your challenge will be to overcome the temptation to use your predominant position in broadband to protect your traditional cable business.
Remarks of Chairman Tom Wheeler, NCTA-INTX 2015, (as prepared) at 6. 

Chairman Wheeler points out that MVPD's spent $26 billion on programming in 2013, but he doesn't mention that as this number grows, MVPD profit declines.  Wheeler Speech at 3.  According to data relied on by the FCC, programming costs (as a percentage of revenue) were the highest in 2013 that this expense had ever been. 16th Annual Video Competition Report, at ¶ 89.   Meanwhile, also in 2013, the same companies invested even more in the means of production for broadband Internet service ($28 billion (according to U.S. Telecom data) vs. >$26 billion (which includes non-ISP DBS firms' spending on content).

If Profit = Incentive, Who Profits from Keeping Content Off the Internet?

Chairman Wheeler is correct in his (implicit) premise--that the parties that benefit most from the status quo do not tend to willingly embrace disruption of the status quo.  But, the Chairman is mistaken about who benefits from maintaining the inefficient, and artificial, separation of the function of content delivery into the "MVPD" business and the "broadband Internet."  If the FCC ever thought to ask itself why these two businesses were still separate businesses at all, the Commission might want to "follow the money."

Profit Margins ISPs v Big Content3.jpgThe table above compares profit margins (income/sales) of the largest ISPs and the largest providers of MVPD content over the past 4 years.  Looking at the relative profitability of content distribution, versus broadband Internet/MVPD--and recognizing, as noted earlier, that the ISPs would be more profitable without their MVPD businesses--then there's really no question that the group which benefits most from the "traditional cable business" is not the ISPs/MVPDs, but rather, Big Content.  

But, even though Chairman Wheeler's assumptions about ISP's incentives are mistaken, he correctly observes that,

      The Internet will disrupt your existing business model. It does that to everyone.

Wheeler Speech at 6.  But, if you're a big content guy, at least he wasn't talking to you--you still get to distribute your content through the free-from-Internet-competition biosphere of the federally regulated MVPD model.  It could be worse, look at Netflix's profit margins . . .
Netflix Profit Margins 3.jpg
The graph above was part of a Seeking Alpha article by Amit Ghate.  Of course, the Big Content companies would probably expect to earn much better profit margins than Netflix, because they have more--and better--content.  But, still, how much better? 

Until now, the Big Content companies have been lucky that the FCC thinks their content needs to be protected from the ISPs.  At some point, though, its always possible that the FCC--or Congress--could start questioning whether parts of the existing pay-TV regulatory scheme are insulating content from the disruptive forces of the Internet.  If I was a content company, though, I would only get worried when they stop inviting me to secret meetings about MVPD mergers.