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Article27 Feb 2015

Is the Current Telecom Regulation Helping Economic Growth?

Citi GPS Opinion Article
Imagine the owner of a motorway who was keen to dominate the haulage business. He may think that advanced knowledge of motorway maintenance closures could give his transportation arm a competitive advantage. Such a synergy-driven combination of infrastructure and service businesses may be beneficial for the infrastructure owner, but it may harm competition in the service business (in this instance haulage), potentially resulting in higher prices and less service differentiation. Luckily, road owners have stayed away from the transportation business, allowing full and fair competition among transportation companies, which all use the same roads. In a similar way, airport owners usually stay away from operating airlines and electricity and water companies do not aim to dominate markets for electricity and water appliances. Interestingly, even PC and smartphone manufacturers experienced a major boom after their hardware and operating systems were separated.

That said the concept of infrastructure and service separation is not prevalent in all industries. Many national railway infrastructure owners still monopolize national train services. National telecom operators held similar monopolies for nearly 100 years, keeping full control not only over their network and the services provided on them, but also over the equipment their customers used. Technological progress such as the arrival of fax machines made such control untenable and telecom monopolies were initially forced to open up their networks to a wider range of equipment. The US authorities subsequently broke up the AT&T monopoly, which together with increased infrastructure competition using new technologies (such as cable TV and wireless) and interconnect regulation, paved the way for telecom liberalization around the world.

In contrast to the past century, today's consumers enjoy a wide range of alternatives when it comes to communications services. Many consumers, particularly those in the developed world, have multiple Internet connection options — fixed-line (DSL), cable TV, wireless and in some areas also fiber technologies — and the Internet itself provides them with vast amounts of free or cheap information (content). In line with the principle of net neutrality, telecom operators have very limited power to filter or prioritize Internet content for their own commercial benefit. As a result, the Internet has managed to empower individuals against various legacy businesses or even authorities by offering cheap and easy access to content as well as the ability to create and share content, make more knowledgeable purchasing decisions and even find new forms of entertainment. Given all this, there is little doubt about why Internet penetration has skyrocketed globally. Contrary to popular belief, this growth has not been driven just by technology, but crucially also by two fundamental consumer-biased policy concepts: telecom liberalization and net neutrality.

World leaders starting to re-evaluate telecom and Internet regulation
The rapid rise of the Internet is however creating challenges. Growing unease of the world's population about the speed of technological change was one of the key themes at this year's World Economic Forum in Davos. Issues of concern range from the loss of privacy, threats to security and the psychological consequences of excessive exposure to the virtual world (e.g. loss of real human relationships) to the impact of the Internet on regional economies. Debates about key regulatory dilemmas such as net neutrality are increasingly attracting the attention of world leaders. Meanwhile, differences in views on this subject between the US President Barack Obama and the German Chancellor Angela Merkel were made clear towards the end of 2014 when both leaders specifically commented on the subject. As also reflected in the latest FCC decision, the US stance is increasingly pro-neutrality, which means regulating Internet service provision as a public utility. In Europe, Angela Merkel has argued against net neutrality and called for a two-lane Internet — one for special, high priority service and another that’s meant to resemble the Internet as it exists today. The European stance is reflected in the European Digital Agenda, which aims to structure digital industries to promote across-the-board economic growth.

It is currently hard to say whether and when the EU may succeed in implementing a fundamental overhaul of its telecom and Internet regulation by applying the following measures: (a) wider opening of communications networks and Internet of Things opportunities to local industries; (b) attracting more long-term capital into telecom infrastructure; (c) attracting investments into telecoms by allowing better monetization of the true economic value of telecom infrastructure; (d) forcing efficiency and scale effects on the existing telecom industry; and (e) some rebalancing of power from the global Internet and tech giants towards local industries including telecommunications.

The EU political leadership in our view currently has the incentive, the right conditions, as well as the determination to overhaul telecom regulation. There are also some good examples globally of pro-growth regulatory initiatives in Israel, Australia and the UK. Based on recent financial investor meetings on this subject we have confirmed that investors are starting to take the possibility of a progressive reform in the pan-European telecom regulation more seriously. Although the European Digital Agenda should conceptually make a positive difference for Europe's global competitive positioning, it continues to face challenges in two main areas. Firstly, similarly to the pan-European integration process as a whole, it faces a lack of willingness by national governments to escalate powers to the EU, especially when revenue collection is involved. Secondly, there is relatively material political opposition in the European Parliament against compromising net neutrality as a principle.

Cracks in the basis of telecom and Internet business model
We see two fundamental flaws in the current policies around the telecom and Internet companies. Ironically, they are both closely linked to the major concepts, which have helped to create the Internet as we know it today.

1. Telecom liberalization reforms of the past three decades have conceptual flaws and they have failed to establish a sustainable model for telecoms and the Internet; this may eventually impact global economic growth.

Unlike in motorways, airports, electricity or water utilities, telecom infrastructure owners often attempt to monopolize or at least lead the market for services offered on their infrastructure. Similarly to the motorway example, such a model may harm service competition in telecoms and hence adversely impact the economy. Telecom operators often justify the lack of service competition using a concept called infrastructure competition, i.e. the existence of parallel networks able to deliver comparable service, which according to the operators, assures competitive pricing and service differentiation. However, the infrastructure competition concept in telecoms in its basic form has severe flaws, both practical and conceptual, as also pointed out by last year's Nobel Prize laureate Jean Tirole.

In cases where multiple competitors have equal resources such as spectrum, technology and access to sites, infrastructure competition tends to produce unstable outcomes. The key differentiating factors in these cases become price and investment. Unless the market evolves into an oligopoly, scale economies encourage all players to stay competitive at all times and essentially match their rivals' moves. This easily leads to price and capital expenditure wars which are hard to overcome without a cut in the number of competitors or arbitrary regulatory interference. Many mobile markets — including the European ones — have demonstrated this.

A different situation arises when one competitor has an infrastructure advantage such as better spectrum, technology or site access. This situation could theoretically produce a stable outcome when the superior network — such as cable TV vs. legacy DSL fixed-line— attracts pricing premium. In practice, however, scale economies encourage the superior resource owners to price competitively and dramatically reduce the inferior resource owners' market share and profits. Customers are usually reluctant to choose an operator, whose service quality is clearly inferior versus the mainstream, even when it comes at a material discount. This explains why it is sometimes hard to competitively challenge infrastructure-dominating incumbents. This concept is easily seen in the US fixed-line broadband access market, which was designed purely based on infrastructure competition. Following the Federal Communication Commission's (FCC's) recent reclassification of high speed broadband (to over 25 Mbps) more than half of US families do not have a choice for their fixed-line broadband provider. In the road analogy, they would only be able to use the motorway when also using vehicles provided by the motorway owner. Their only alternative is to use slow roads.

In summary, telecom liberalization reforms of the past three decades may have been driven not only by excessive focus on the consumer as opposed to business-to-business (B2B), but also by excessive expectations from infrastructure competition and often insufficient conceptual appreciation of service competition. In our view, such an imbalance may have affected the current efficiency of the telecom industry, which itself plays an increasingly important role as the backbone of global economies. However, Market forces and natural processes are already rectifying this. Since 2012, when global wireless revenue slowed to low single digit levels we have seen wireless in-market infrastructure consolidation around the world, starting with towers and expanding into networks and entire mobile businesses. Meanwhile, we have also seen rise of new forms of service competition through Over-The-Top (OTT) players such as Skype, WhatsApp, FaceTime, etc. It is hard to argue that the telecom liberalization concepts designed in the 1980-90s reflect such reality. The fact that telecom regulation often differs country-by-country, and such differences are hard to explain by objective geographic, demographic or other reasons, is another sign of conceptual weakness of today's telecom regulation.

2.The so far prevalent concept of net neutrality has created enormous global scale economies and subsequent wealth concentration in the Internet industry, the positive global economic benefits of which are debatable.

Net neutrality, a framework in which telecom operators cannot interfere with content, (i.e. they cannot allocate more capacity to YouTube videos over other video services), has so far been prevalent globally. The best analogy to neutral networks is a road system with the same rules for all cars with no toll roads allowed. Neutral networks cannot manage their bottlenecks, guarantee service quality or accommodate special needs for speed and capacity. This has had two consequences. Firstly, the fact that content providers do not pay the telecom operators for delivery of their content has created enormous global scale economies in content aggregation. This has allowed the leaders in different segments, such as the so called GAFA companies (Google, Amazon, Facebook and Apple), to practically dominate their markets globally. Secondly, the newly emerged Internet industry has been largely consumer-focused as opposed to B2B focused.

Owing to scale economies and innovation, the global Internet leaders have created unprecedented value in the last ten years. The world's top five Internet companies are now worth more than the top five telecoms with Apple now reigning as the world's most valuable company. Internet has created unprecedented personal wealth as well, similar to railways, oil, PCs or telecom networks in the past. Key shareholders of the Internet companies such as Mark Zuckerberg, Larry Page, Sergey Brin or Jeff Bezos may be in that sense compared to John Rockefeller, Bill Gates or Carlos Slim.

Like the railway, oil, PC and telecom industries, the Internet industry also allows consumers to benefit from technological innovation while disrupting some legacy industries. There is however one significant difference. Railways, oil, PCs and telecom sectors opened up new opportunities for a range of other industries by boosting the efficiency of legacy production processes. This contributed to economic growth and value creation across the economy. Meanwhile, the current Internet aggregators such as the GAFA companies largely bypass legacy industries and target the consumers directly while often disrupting legacy businesses.

While this phenomenon empowers the consumer and may even lead to price deflation, its positive impact on the growth of local economies remains debatable. The abundance of free content on platforms such as Facebook may even be seen as diverting users' attention away from economically productive causes. Meanwhile, the Internet industry will continue to have a major disruptive effect on local industries ranging from music, telecoms and media to retail, transportation (e.g. taxi services) and financial services. It is highly unclear whether the adverse economic implications of such disruption will be compensated by the creation of new industries with wide-spread new employment opportunities (such as the app or on-line gaming industry). Relatively advanced economies, which do not directly benefit from the expansion of the Internet industry, appear particularly at risk.

Finally, unlike the oil and telecom industries at the time of their rapid growth, today's Internet industry does not directly create large scale new investment or employment opportunities which would drive economic growth. Despite its ability to extract value from economies around the world, the Internet industry's contribution to tax revenue is relatively small as well. That said the Internet industry is playing a positive role in the economy by driving broadband penetration in the developing world, driving crucial R&D projects in the area of robotics and artificial intelligence (including for example driverless cars) and more controversially creating extensive and highly valuable databases about the world's on-line population ( so called big data). Some of these activities may continue supporting economic growth, although this may appear more long-term and less certain compared to the adverse growth implications of the Internet industry's disruptive effects on the legacy industries.

Regulation and innovation has so far focused on the consumer, but business innovation needs to drive growth
It is interesting to note that the common denominator of the above-discussed challenges is a highly pro-consumer bias and not always the conceptually sound policies of telecom liberalization and net neutrality. Could a policy overhaul create an environment more supportive of economic growth? In our November 2014 Citi GPS report Re-birth of telecom monopoly: Is the industry broken and heading towards its monopolistic roots?, we addressed the issue of the optimal business model for telecoms and Internet companies. We argued that a regulatory policy overhaul may be desirable not only due to the conceptual weaknesses of the current policies and the saturation of wireless and Internet markets globally, but also due to newly emerging opportunities in technology. Telecom, Media & Technology (TMT) growth in the past ten years was dominated by content aggregation, exploitation of global scale effects and smartphones. We expect future growth will be driven by connected intelligent devices such as robots, driven by the Internet of Things (IoT).

There are two key differences between the IoT and the current Internet business models in our view. Firstly, the innovative IoT solutions may be designed, marketed and provided by a wide range of companies across the world, each of them able to purchase connectivity and high tech solutions on a wholesale market. For example a local hospital may provide a specialized personal health monitoring service. The hospital would be able to buy the high-tech solution from a technology company and the necessary connectivity from a telecom company. Secondly, failure of connectivity in the IoT solutions could be detrimental to the usefulness of the final product, potentially including safety and security of their use. Therefore it is imperative that providers of such solutions are able to purchase connectivity at the required quality levels, which may differ based on the type or use of the product. This makes a strong case for so called guaranteed services, i.e. premium quality connectivity at a premium price specifically devised for a certain product. This directly contradicts the net neutrality principle.

The key economic benefit of the IoT model compared to the current Internet business model is that it would help to somewhat de-centralize innovation and balance-out its benefits more evenly between the leading Internet and technology companies (such as the GAFA companies) and innovative companies in their respective industries around the world (for example car makers for connected car solutions, universities for education solutions, pharmaceutical and health companies for health solutions etc.). IoT may boost production efficiency and product functionality of the existing products, reduce costs of some products as well as create brand new products such as robotic cars. The fact that this would happen across economies could mitigate some disruptive effects of the Internet-driven innovation on economic growth.

Solution: Regulation, which is friendlier to wide-spread business innovation
Why has IoT not made a bigger impact yet? One reason is technological. Robotics and smart technologies take time to develop, while big data takes time to collect and utilize. However, another important reason is regulatory. Telecom and Internet regulation has been driven predominantly by consumer interests, which have so far largely coincided with the interests of the Internet industry such as the GAFA companies. Meanwhile, regulation has not yet taken into account the innovative opportunities in specific industries or regions, which may require different levels of guaranteed connectivity.

In our Citi GPS report we outline our SECOND (Selectively Competitive Net De-neutralised) model for telecoms, which attempts to address this problem. It calls for replacing infrastructure competition and potential net neutrality dogmatism with a new concept, which draws a dividing line between the infrastructure (real estate-like) and innovative parts of the telecom businesses. The infrastructure business may be allowed (although not forced) to consolidate and in some areas (such as towers, passive infrastructure, rural broadband access networks, etc.) possibly to re-monopolize.

The key issue in infrastructure is consistent application of the wholesale concept in both the monopolized and competitive infrastructure while minimizing synergies between owning infrastructure and providing service on it. This is crucial for two reasons. Firstly, it would open up the communications market to innovators across all industries. Car companies, security companies, financial services companies, gaming companies and others would all be able to offer their service directly to the customer, including connectivity with parameters tailored to the need of the ultimate service. Secondly, abundant choice of communications service providers with access to top infrastructure would effectively remove the need for net neutrality. Service providers would be able to prioritize traffic based on economic needs (e.g. providers of health-related applications may purchase wireless connection with guaranteed reliability while movie download providers may get super-fast speed with less reliability guarantee). Low entry barriers into the service business should in principle prevent service providers from taking unfair advantage of the consumers in the non-net neutral environment, although specific aspects of net neutrality may still be regulated.

In a transportation analogy, our SECOND model would compare to a situation when road owners must allow all licensed cars (or transportation companies) to use the roads with the same traffic rules for all. It would be possible, however, for road users to pay a toll for using faster roads or certain tunnels and bridges. Businesses, which fundamentally require fast transportation (e.g. food, transport) would have better conditions to thrive in such an environment. While offering the widest possible access to the basic infrastructure, the SECOND model would also allocate scarce telecom infrastructure capacity to different uses based on their economic value (rather than a principle of equality). This arrangement is in our view not only optimal for using the infrastructure to grow the economy, but it is also the best possible sustainable free-market based driver for infrastructure investments. It should in a way allow the infrastructure investors to benefit from the true economic value of the infrastructure while it removes the costs of unnecessary infrastructure duplication.

The ultimate version of our SECOND model is the so called structural separation of telecom infrastructure and service, i.e. full ownership separation, when the infrastructure companies potentially re-monopolize certain markets and exclusively focus on wholesale. The fixed-line structural separation in Australia, the functional separation in the UK fixed-line, the tower and network consolidation currently ongoing around the world, the ongoing net neutrality debate on both sides of the Atlantic, the recent Google MVNO (mobile virtual network operator) deal in the US and the world’s first ever incumbent-driven proposal for full (fixed-line and mobile) structural separation by O2 Czech Republic can all be seen as moves closer to the SECOND model.

Obstacles facing the SECOND model and opportunities for Europe
Despite the above-discussed developments, it has so far been hard to see too much enthusiasm around the world for overhauling telecom and Internet regulation to support across the board economic growth. Why? The reason may be that stakeholders who could benefit from such an overhaul have so far been less vocal than those who may face the risks. Shareholders of the leading telecom operators may benefit from structural separation, but telecom executives may naturally see destabilization of the established business models as risky, particularly for companies with 'empire building’ strategies. The Internet companies led by GAFA would naturally be careful about any model which may force them to share more value with infrastructure owners, other companies or governments. Meanwhile, the public and its political representatives may also be sensitive about compromising the net neutrality concept, which is often linked to freedom of speech and portrayed as one of the key achievements of the past decades. Finally, industries that could potentially benefit from compromised net neutrality and the IoT, or lose out if the status quo is sustained, have not yet joined the debate with a strong voice.

Another barrier to application of the SECOND model ideas is the current state of the telecom and Internet industries in different countries. The US for example does not have a well-developed wholesale market in fixed-line broadband access. It is also hosting a large share of the global tech and Internet industry, which materially contributes to its economic growth. This, along with strong political opposition against anti-neutral regulation, complicates potential compromise on net neutrality there. Meanwhile, Europe has historically recognized wholesale competition in telecoms as a principle, it has largely missed out on the Internet (content aggregation) opportunity while it has leadership in certain industries (e.g. manufacturing such as cars), which may potentially benefit from moving into the IoT or lose from staying out. It is therefore natural to see that the US political leaders are more inclined to speak in support of retaining net neutrality while the European political leaders are more tempted to compromise it.

GPS Opinion

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