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. 




May 11, 2015 11:25 AM

Why Net Neutrality Won't Give Consumers More Online Linear Content

In its recent Net Neutrality/Broadband Reclassification Order, the FCC justifies the need for the Order's pervasive regulations in essentially one statement, "broadband providers (including mobile broadband providers) have the economic incentives and technical ability to engage in practices that . . . harm[] other network providers, edge providers, and end users."  Order ¶ 78.  The Commission's discussion of the ISPs' incentives/ability to harm consumers and other market participants is almost as conclusory.

The FCC appeared focused on a result that required it to presume an uncompetitive broadband market.  Supporting its premise, the FCC relies on citations from its 2010 Order, and some gerrymandered market shares, in which it defines "markets" by arbitrary selections of speed vs. consumer demand substitution.  See, e.g., Order, n. 134.  By ignoring broadband market performance, the Commission not only failed to understand that ISPs were unlikely to be the problem, but the FCC also missed a chance to conduct a more circumspect analysis of whether consumers could truly access the content of their choice online.

The FCC Didn't Consider Broadband Market Performance

The FCC states that, "[b]roadband providers may seek to gain economic advantages by favoring their own or affiliated content over other third-party sources." Order ¶ 82.  The Commission offers less than a handful of specific examples ISPs "act[ing] to harm the open Internet." Order, n. 123.  

Only in the Madison River example, was the ISP clearly seeking to favor its own service (long distance voice termination).  It is worth noting, though, that the reason Madison River had an incentive to favor its circuit switched voice was because--as a rural ILEC--the FCC set Madison River's rates well in excess of cost; so its incentive was created by one FCC regulation and then preempted by another (later) FCC regulation.  

Nonetheless, the best indicator of a market is performing competitively is whether it is responding to consumer demand by adding capacity, or whether it simply raises prices and takes more profits.  Broadband speeds have consistently moved higher, actually following  the Moore's Law trajectory.  And, the Commission notes, broadband capital investment reached levels in 2013 that had previously only been seen during the telecom bubble.  Order ¶ 2.  Moreover, connected devices, bandwidth speeds, and user adoption of streaming services has soared.  Order ¶ 9.    

The FCC Didn't Consider the Evidence on ISP Incentives

The Commission recognizes that, "the growth of online streaming video services has spurred further evolution of the Internet."  Order at ¶ 9.  But, untethered by evidence to the contrary, the FCC leaps to the [wrong] conclusion that, "these video services directly confront the video businesses of the very companies that supply them broadband access to their customers." Id.

Almost a year ago, AT&T Chairman Randall Stephenson, explained why this theory didn't make sense for most ISPs.  In his prepared testimony for the House and Senate Judiciary Committees about the AT&T's proposed acquisition of DirecTV, Stephenson states its motivation to acquire DirecTV is about trying to earn any profit on TV,

Today, 60 cents of every video dollar we earn goes straight to programmers, before we spend a penny to market our service, install a set top box, send a bill, or answer a customer's call. As a result, our video product is, on its own, unprofitable.  
Statement of Randall Stephenson, CEO and President, AT&T Inc., before the House Judiciary Committee, June 24th 2014 at p. 3 (emphasis added).  Thus, the FCC's theory--that ISPs have an incentive to prevent consumers from accessing video content online, because the ISP would prefer to sell them the same content at a loss to the ISP--is simply untenable.

Even if the ISP does earn a profit on video, it would still not have any incentive to discourage their broadband customers from accessing online video content, unless it earns a greater profit from its  video service than from its broadband service.  This is not the case for Comcast, whose broadband revenues and company profits continue to boom, despite continued losses of video subscribers.     

So, if the FCC's theory doesn't even make sense for the Prince of Darkness, then ISPs are unlikely to be the problem.  But, why don't consumers have access to more content over the Internet?

Traditional Linear Content Owners Don't Have the Same Incentives As ISPs

Even though the three largest streaming video providers (Amazon, Hulu, and Netflix) have expanded their content through original programming, and consumers have embraced online streaming video, the fact is that consumers still don't have access to that many more online programming choices than they did in 2010.  If you compare the most popular streaming sites in 2011, with what's available today, the only significant new entrants are Sling TV and HBO Now.  Unfortunately, cord-cutting is more of a media headline than a consumer phenomenon.

At times, the FCC has seemed to (sort of) recognize the problem. A little over a year ago, Chairman Wheeler was telling broadcasters that he was looking out for them with strong net neutrality protections, and that they should embrace Internet distribution of their programming.  Except for the few broadcast channels that are part of the Sling TV package, the Chairman's speech fell on deaf ears.  Chairman Wheeler didn't seem to appreciate that--because the FCC ensures the broadcasters fat margins on retransmission fees (much like Madison River's terminating access margins)--they have no incentive to expand output!  

Similarly, Chairman Wheeler understood that the linear content market had failed last summer, when he asked the CEO of TWC to resolve disputes between TWC's regional sports network (RSN), which carries the Los Angeles Dodgers, and other MVPDs serving the Dodger's home television market.  Because of pricing disputes, when Chairman Wheeler wrote to TWC, a large majority of Dodgers' fans--4 months into the 2014 baseball season--could still not watch the team on TV.

Chairman Wheeler probably thought he understood TWC's incentives pretty well--the company had a merger with Comcast pending before the Commission--when he asked TWC to respond in a competitive manner to consumer demand.  But, RSNs have powerful economic incentives to restrict output.  Thus, Chairman Wheeler was, again, mistaken about incentives.  TWC's merger with Comcast has come and gone, but 70% of the Los Angeles viewing market still cannot watch the Dodgers on TV or online.   
 
A Question of Incentives

As of Friday, Chairman Wheeler was [still] telling cable ISPs they should "overcome their temptations" to favor their TV businesses over their broadband Internet services.   Meanwhile, in an L.A. Times article yesterday, broadcast programmers candidly noted that, despite using public spectrum to distribute their content, they plan to favor even more of their own content over third party sources.  Perhaps the Chairman was talking to the wrong group?    

By now, you probably understand that I think the FCC would have been wise to spend some time thinking about whether the industries it regulates have incentives that are aligned with consumer welfare.  Had the FCC thought about it, they probably didn't need to impose such pervasive regulations on ISPs.  Likewise, if the FCC's rules are distorting the incentives of traditional TV programmers, then the FCC should eliminate these rules, also. 

On the other hand, what if traditional linear programmers simply like their FCC incentives more than those of the competitive broadband Internet, and are simply in "harvest" mode (restricting output/raising prices in the face of a slow decline in demand)?  Broadcasters aren't (usually) ISPs, so who will police them? 

Certainly not the FCC.  But, to be fair, neither have the DoJ or the FTC looked into the matter.  However, some parties are looking out for consumers . . . and the answer may surprise you.  We'll discuss further in the next post. 






 

March 4, 2015 12:42 PM

The FCC Avoided a Bigger Disaster on Interconnection . . . for Now

In case you didn't notice, the FCC's press release describing its decision to reclassify broadband Internet access is a little different on the subject of interconnection than Chairman Wheeler's "Fact Sheet" 3 weeks earlier.  The FCC's press release from last week is substantially similar to the Chairman's fact sheet, except that it contains no reference to the classification of  the "service that broadband providers make available to 'edge providers.'"

The Chairman's "Edge Service" Classification Proposal Was Really Unpopular

On the last day that parties could lobby the Commission, (February 19th) Google had meetings with senior advisors for the Chairman and the two Democratic Commissioners.  In these meetings, Google persuasively argued that "the Commission should not attempt to classify a "service that broadband providers make available to 'edge providers,'" because "this supposed additional service does not exist." Ex Parte (Internal quote to Chairman's "fact sheet.")   On the eve of the Commission's vote, the Wall Street Journal reported that "the FCC tweaked its language to address Google's concern."  

Without this report, it would be hard to know who to credit for killing a truly reckless idea.   That's because the following 5 parties all made arguments against the Chairman's proposed "new service" on the same day as Google:  Akamai, Free Press and New America's Open Technology Institute, National Hispanic Media Coalition, and Cox Communications.

When you somehow manage to get Free Press, New America, and the National Hispanic Media Coalition to oppose an additional Title II regulatory classification--because it makes your original Title II reclassification look even more legally suspect--that's when you know you've gone too far.  

The Importance of Direct Interconnection Agreements

The scariest aspect of the Commission's proposal must have been the FCC's casual willingness to disturb these companies' existing arrangements with ISPs by mandating the future terms on which they and others would be able to obtain interconnection.  For companies with little to no regard for the terms of their existing interconnection agreements, like Netflix and its transit vendors, the Commission could not make their situation worse.  But, for the leading Internet companies, the Commission must have appeared alarmingly ignorant of/indifferent to the importance of these agreements to Internet traffic delivery.

Reason 1:  The Disintermediation of Internet Traffic

In 2009, the University of Michigan, Arbor Networks, and Merit Network presented the results of the largest traffic study since the advent of the commercial Internet.  The study showed that, between 2007 and 2009, Internet traffic delivery changed radically.  Over only 2 years, Internet transit (the traditional "intermediary" between ISPs) became dramatically less important as a traffic delivery vehicle.  

Instead, major content providers began delivering more and more content directly to the consumer's ISP (either through their own networks or CDNs).  Accordingly, since 2009, the "tech giants" have been accelerating their investment in network assets and data centers to route their high bandwidth traffic directly to efficient delivery points in the ISP's networks.

Reason 2: Interconnection Agreements Reflect Valuable Investment

As the Internet has evolved to more efficiently deliver high-bandwidth content to consumers, the largest content providers--including Netflix for the first 4 years of its streaming service--have placed a premium on placing content closer to the customer.  Therefore, the largest traffic sources have entered into agreements to directly exchange traffic with their customers' ISPs.  When these agreements provide for the settlement-free exchange of traffic, it is because this reflects the mutual benefits received by both parties.  

CapEx Graph 1.jpgSince parties to settlement-free "peering" arrangements each provide the other with valuable network facilities, or other benefits, this value can be observed by looking at the investment the parties put into their networks (i.e., capital expenditures).  To get an idea of the importance of those agreements to Internet companies, consider the increase in capex by the largest Internet companies since 2009.

Regulation of Interconnection Terms Could Devalue Previous and Future Investment

As we can see from the chart above the major Internet companies have undertaken a massive amount of capital spending over the past 6 years in order to efficiently deliver content and services to consumers.  To be sure, not all of the Internet companies' capex is driven by traffic delivery interconnection concerns, but the increase in these companies' capex since 2009 correlates with the findings of the University of Michigan, et al., traffic study referenced above.  Moreover, news reports have confirmed spending on improved data networking infrastructure as a capex driver. See, e.g., here and here.   

This capital investment has been made by edge companies and CDNs with the expectation that it will allow these firms to provide a better experience to their customers than their competitors provide.  Indeed, Google notes that it has entered into peering agreements with some of the largest ISPs because it is "unable to use transit to reach users on those networks with reasonable quality." Ex parte at 2 (emphasis added.)

The risk of requiring ISPs to provide interconnection as a separate common carrier service was articulated succinctly by Akamai, which handles 15-30% of the world's Internet traffic.  Akamai argued that the FCC must not mandate the terms and conditions of ISP interconnection, because if the ISPs are required to provide access on equal terms to all:   

This is not technically feasible and the result could be access for none, which would decrease the performance, scalability, reliability and security of the Internet.
Akamai, February 20th ex parte at 1 (emphasis added).  In other words, Akamai understands and accepts that it "must often compete with others for access to ISP facilities."  Akamai, February 9th ex parte, at 3 (emphasis added). But, does the FCC accept interconnection as a legitimate element of competition?

CapEx Graph 2.jpgThe Commission Should Not Displace Competition with Regulation

Netflix, Cogent, and Level 3 assert that they cannot get interconnection with the ISPs--on the terms they would prefer--because of a lack of competition.  But, as Akamai explained, companies seeking the most efficient terms of distribution to the ISP's customers are competing with each other for the best access to these customers.  Could it be that competition is the reason the transit companies aren't getting the terms they want?

Compare the sum of the capex of Netflix's distribution chain over the relevant time period, with their competitors.  Is it surprising that Internet transit wants the FCC to "level the playing field?" 

Transit is at a disadvantage relative to direct interconnection because the Internet has evolved.  For the content distributors sending the most traffic, transit has not been the preferred solution for a long time.  But competition, and not a lack thereof, produced this outcome.  

Unlike the major focus of the larger net neutrality debate--which is concerned with adopting rules to foreclose future ISP service offerings--the regulation of interconnection terms and conditions is fraught with risks to existing service configurations.  The FCC must be careful not to use prescriptive regulation of ISP interconnection terms--in the name of competitive "neutrality"--to foreclose innovative firms (and their customers) from reaping the benefits of their own ideas, risks, and investments.

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CapEx Data Table.jpg