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Summary:

While the Internet has evolved, U.S. Internet service providers have not kept pace. And their lagging is costing them money, which they are now looking to pass onto the consumer in the form of usage-based pricing.

According to AT&T, Time Warner and others, usage-based pricing is coming to your Internet connection. While the reasons for this change in pricing model are varied, both in terms of technology and politics, it’s clear that consumers used to an “all-you-can-eat” buffet of streaming video, photo-sharing and podcasts are headed for a lean diet of Web 1.0 and email. Unless, of course, you want to pay a lot more for your Internet connectivity.

How much more? While the service providers have not announced their pricing plans, it seems clear that usage-based pricing will be based on the number of bytes you send and/or receive from the Internet on a monthly basis. Time Warner has suggested that usage-based pricing will be tier-based, with tiers at 5, 10, 20 and 40 gigabytes and overage charges applied for bytes that exceed them.

To put those numbers in perspective, here in the Bay Area I subscribe to AT&T DSL for $24.99 per month. I can download at 1.5 megabits per second and upload at 512 kilobits per second, which means I am bit-rate limited to downloading 500.2 gigabytes per month, or about 20 gigabytes per dollar. That same $24.99 per month also allows me to upload 165.9 gigabytes per month, or about 6.6 gigabytes per dollar. But to keep the pricing simple, let’s assume that I’m currently paying 5 cents per gigabyte sent or received. Granted, I may not consume all of these gigabytes every month, but in theory, I could.

I think it’s safe to assume that the service providers will price their usage-based tiers at amounts comparable to today’s monthly fees. They’ll want to lure in customers to the lowest price tier and then gouge them with overage fees. So let’s assume that the lowest priced usage-based tier, 5 gigabytes, costs $10 per month. That equates to an increase in my current fee of 40 times, to $2 per gigabyte. The highest tier, 40 gigabytes, will undoubtedly cost the same or more per gigabyte. If we assume that this tier will be priced at the same cost per gigabyte, then that equates to $80 per month. And again, that’s without overage fees, which will undoubtedly be as hefty as the surcharges on cell-phone plans.

As a rough reference, 5 gigabytes is the equivalent of doing one of these activities over the course of a month:

  • downloading about 1,000 songs from iTunes (assuming about 5 megabytes per song)
  • downloading five full-length movies from iTunes (assuming a two-hour movie)
  • watching about 500 minutes of YouTube video (a quick test I just ran shows that a 2.5-minute video is a 5-megabyte download)
  • sharing about 2,500 two-megabyte pictures (as normally produced by today’s typical 8-megapixel camera)

These references are estimates and do not account for other ways we typically use bandwidth during a month, among them file backup and recovery; VPN connections to the office; IP video conferencing; downloading Microsoft software upgrades and patches; use of cloud computing sites such as Google Docs and Amazon’s EC2; and so forth.

Of course, service providers will argue that in reality I do not consume 500.2 gigabytes of data each month, that my effective cost per gigabyte is higher than 5 cents and closer to the usage-based prices. And if I’m only browsing the web, doing email with small attachments and downloading the occasional picture, then my usage should fit in the 5-gigabyte usage tier and my monthly bill could actually go down. But that’s not the point — the point is that the unit economics of the Internet have changed and consumers are going to increasingly pay more for each byte of data delivered to them.

Why have the unit economics of the Internet changed so dramatically? “We built a road that was well-suited for bikes and cars and spent the money to build and maintain that more or less properly,” was the way one service provider executive explained it to me. “Now we have folks landing planes on the road, tearing it to shreds and making it unusable for others. So we need to spend lots more to maintain the road for bikes, cars and planes.”

Infrastructure technology like terabit routers, 60-gigabit backbone connections and multimegabit broadband connections do exist to support bikes, cars and planes — but the service providers have failed to spend the money from your Internet connection fees to invest in that infrastructure. Instead they have spent it supporting their bloated organizations and devising new pricing models to extract more money from consumers for less service delivery.

And therein lies the rub: The Internet has evolved and has enabled new applications such as peer-to-peer and video streaming that are increasingly being used by the consumer. Unfortunately, the infrastructure evolution of service providers like AT&T and Time Warner are working at a significantly slower pace. And that slower evolution costs them money, because their infrastructure cannot handle the new Internet applications, so instead of building efficient organizations that can evolve and deploy infrastructure faster they are looking for more money from the consumer in the form of usage-based pricing.

One day soon, when you get your Internet connection bill and it is much larger than you expected, don’t blame Hulu or Microsoft for offering you funny videos or a new security patch, blame your service provider for not evolving with the Internet.

  1. This is a problem with a duopoly. If there was was more open competition, the organization bloat would be cut very sharply. This is however, not a problem that is going to be solved any time soon, because the mass investment needed to bring infrastructure to the folks simply is not going to be available. We are talking multiple tens of billions of dollars for the US alone. Let aside the regulations and permitting process.

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  2. Am I alone in thinking this will spur CLECs? As in — at least for DSL connectivity — folks like Covad or even not-CLECs like Speakeasy, Sonic.net, DSLExtreme, etc, will easily attract more customers as they are NOT usage-based? This just reeks of telephone companies shooting themselves in the foot.

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  3. This is lame analysis.

    500G if you use your bandwidth at the theoretical maximum for the entire month. Please, do you seriously think that is how the carriers have built their business plans and pricing models or that is what 99.9% of consumers think they are buying?

    And the piece reeks of an anti-big business philosophy: “They’ll want to lure in customers to the lowest price tier and then gouge them with overage fees”. Give me a break.

    This is a fair topic to discuss and the outcome will affect some consumers, but let’s get real with the analysis and skip the socialist underpinnings.

    In my view, everybody’s gotta make a buck – even big companies. And a few people who are massive bandwidth hogs shouldn’t get a free pass.

    As I understand these potential pricing plans, most folks won’t see a damn thing change. Bigger bandwidth consumers may, probably will. Is that so wrong?

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  4. Allan,
    You nailed it. When you are a $20B/yr monopoly all your energy is around preserving the cash machine. There is no incentive to invest and all kinds of excuses and explanations about how they want to get more cash from you for their existing plant

    Steps to maintain a thin-net monopoly as follows:

    (i) Promise counties and state governments “information highway” universal service for their citizens in exchange for long term monopolies to the communal rights of way
    (ii) Do the minimum investment to have a product that works, is not quite universal, but keeps complaints down to a dull roar
    (iii) Hire lobbyists and donate to critical county, state, and federal officials
    (iv) Hire lawyers to make it impossible for the FCC, state regulators, etc to interfere with your monopoly
    (v) Tacitly collaborate with the only alternative to your service to collude on pricing – ie. We need to increase prices to invest
    (vi) Invest in metering and billing software so you can get paid more cash for your old infrastructure
    (vii) Invest in preventing all competition – see the 700 mhz auction process; patent lawsuits aimed a Vonage, etc.
    (viii) Repeat steps 1-6 for as long as possible

    It is no wonder that the US ranks last in the developed world for speed of deployment of true broadband connectivity. See the very thoughtful post by Peter Galuszka on “Our broadband fiasco:high-speed connectivity in the U.S. is rolling out in slow motion. Whose fault is it?” where he outs this whole dirty process and Verizon and Comcast’s successful work to kill muni wifi in Philadelphia and the root causes of the problem.

    The only way to stop the cycle is to have netizens, US industry, and all citizens demand better from our elected officials. This stupid idea of charging variable pricing for use might just be the thing to get people of their coach and realize what is going on…..

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  5. As with all things, competition will likely force at least reasonable rates for most of the people most of the time.

    It’s as likely as not some of the reasoning behind these moves, (besides just wanting more cash), is to shut down disproportionate use by some users. There’s likely a typical usage curve that’s got the amazingly profitable folks who pay full freight, but use very little to the other end. Many moons ago, traditional online services and ISPs faced these issues. Prodigy Services Company, AOL, etc. when they first went to flat rate pricing, (mostly because competitive pressures forced them to go there from timed pricing), thought about tiers for out-sized amount of usage of email and so on. The thing is though, at that time there were only so many ways you could really abuse bandwidth. Besides email, there was just only so much stuff out there to suck down.

    Now, of course, things are different. Personally, I think most of this will work out for most of the people most of the time. And quite candidly, tiered pricing might not be a horrible thing. I do understand some prefer to scream about it, but for the vast majority of people who use the median amount of bandwidth, they don’t want to pay for the heavy users. Though I suppose one could argue they’re covered by the light users. In any case, yeah, I don’t personally really want to pay more either since I’m likely on the heavy user end.

    Anyway, from what I’ve been reading lately, ISPs won’t have a ton of pricing pressure given that broadband penetration is stabilizing at something like 65%?? of US households at this point. As much as pricing might be one way to grow, the competition will have to be based on customer retention, not market growth. (Unless they really add some value add premium services.)

    Scott

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  6. @vijay – agreed. We need more competition in the last mile and that will help with both pricing, innovation and maybe even equipment costs.

    @Aaron – see vijay’s comment :) Yes, I am thinking the same way – who will be the first to build a broadband access network without usage-based pricing and leave the current service providers flat-footed? Flat-rate pricing, as we have now on the Internet will always trump usage-based. You only have to look at carriers in the mobile market who aggressively moved their charges tiers of minutes far above the standard consumption.

    @John – I’m not a socialist, but a venture capitalist. Big difference :) It’s hard to escape that the unit economics of the Internet are changing. I’m not sure about you, but in almost everything I buy in my life it is not okay to charge more and deliver less. That is what service providers are doing. Is it my fault that as a big business they cannot build, deploy and operate their services based on the fees they already are charging? Also, who decides if you are a big bandwidth user? What happens if one day the service providers decide that anyone who watches more than 2 hours of HD video over the Internet is a big bandwidth user because they are trying to protect their investment in a satellite TV company?

    @Chris – thanks. I as trying to avoid the politics of the telecom business in this post, but you bring up good points.

    @Scott – good thoughts. I would argue that we’re all going to be paying more for each byte delivered, regardless of usage pattern or tier we choose to subscribe to. That is what the service providers want.

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  7. Good post Allan – nice summary of the conversations at that very-well attended Structure08 cocktail party.

    Vijay has a point about duopoly and inefficiency. It would make sense to support usage based pricing if there was any chance it would lead to infrastructure improvements. Economics (Vijay’s POV) tells us that it won’t work because of the lack of competition. Actual hard numbers tell us the same thing – the US is incredibly far behind the pack in terms of broadband availability and pricing. If the telco overlords (at least that’s how I liked to imagine myself at Cable & Wireless…) had shown any ability to deploy affordable, fast infrastructure historically, they’d get my support for usage based pricing.

    The real problem isn’t pricing – it’s massive bloat, inefficiency, and gouging from telcos, who fritter away subscriber fees on sad acquisitions, illegal support of government spying programs, and the other things on Chris’ list above, rather than spend it on building faster infrastructure. I’m waiting for the day AT&T or Verizon attempt to acquire the California DMV for its superior call center and customer service infrastructure. It’s not like this in the rest of the world. I used to say that in the US we pay for 1st world telco services but get 3rd world telco service, but that’s not even true anymore. The 3rd world often has better broadband than we do here, for less.

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  8. Allan:

    If usage, meaning demand per user were constant, i would agree with you that carriers shouldn’t charge more for the same thing. But usage is not constant, usage by individual users is accelerating because video, music sharing, video calling, and any number of other new bandwidth-intensive applications.

    The fact that the telcos introduced pricing based on a world with demand of x per person and people are now using x times some percent, i don’t see how that is charging more for less.

    If I went to the store and bought milk for $1.99 worth of milk each week and then I doubled my consumption, would i still expect the local dairy to cover me for the same $1.99?

    And most of this is motivated by a relatively small percentage of users who are especially heavy consumers of bandwidth.

    I don’t see anything wrong with carriers seeking compensation for this consumption. If you had a portfolio company that was getting killed delivering to a small percentage of their customers – i.e., some of the customers weren’t profitable. What would you do? Tell them to suck it up? I doubt it.

    The fact that they are large companies is irrelevant to this point. In a regular market, the telcos would just deal with these high end consumers and either cut them off or make them pay more or otherwise find a way to achieve fair economic return to the provider. And then leave the rest of the market alone.

    But because telcos are fairly heavily regulated and scrutinized and there is a common good in universal access to broadband, etc., they must implement a pricing plan that is ‘fair’ to everyone, that passes review by various entities that have a say in their operations.

    And I don’t mean to be an apologist for telcos, but with respect to them being large, that’s the nature of the beast. Large anythings tend to be less efficient than small things (or at least we think they are), but small things often can’t operate massively sized things like, for instance, telecom networks (or efficient search infrastructure). Twitter springs to mind as a good example of that.

    If there were obvious and simple ways to run these large enterprises with higher efficiency, somebody would be doing it. It’s easier said than done. As a venture capitalist, if you have the wherewithal to do it a better way, by all means, have at it. I’m sure the 3% heaviest of users that get kicked off the incumbents’ networks would love to become your first customers at $24.99 a month.

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  9. Great article Allan…I am very much in the mind-set of combating the stasis experienced inside of the monopolies, duopolies, oligopolies and any maturing company (or human); I think that you have uncovered a facet of corporate and human life – the Achilles heel of humanity: entrenched mind-sets and aversion to change.

    Without the incentive of competition, innovation comes to a screeching halt – this is in ample evidence of nearly all things govt (zero competition) and all super large, mature industries with few players – airlines come to mind

    An example from consumer side is the price of oil and our utter dependence upon that now as no innovation of power generation over last 40-50yrs – people have had ZERO incentive to change due to ridiculously low price of oil and thus, the world has avoided the difficult task of seeking alternative energies.

    People (companies) resist change – that is just a simple fact of human nature – look at our decrepit sanitation or water systems…all examples of what happens when there is little incentive to change/evolve/improve…

    How do you combat that – by making the proper incentives and choosing the right leadership. Incentives are the easiest to put into place and simply need to be mapped to what actions you want to come about…leaders are harder to come by, however, when present can change cultures. I think great examples of dynamic companies with great leaders are GE & IBM – both have withstood test of time by evolving, adapting and choosing great leaders.

    Competition also fosters improvement – there is a reason that sports records get beat all the time…improving athletes who are fierce competitors…take away that competition and welcome in stasis.

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  10. Doesn’t anyone see it as suspiciously coincidental that usage-based pricing has materialized just as we’re on the verge of seeing applications that will make *everyone* into “massive bandwidth hogs”? I just finished downloading Age of Conan: about 15 GB. That’s one game. High-def movies: a gig per night, or more maybe? YouTube – in higher and higher quality? Photos, videos, Web 2.0… the list goes on and on.

    This usage-based billing is not only a huge cash-grab, it’s the prelude to an even bigger cash-grab. What’s worse, it’s also an end-run around net neutrality scrutiny. If ISPs can control our usage volumes, they can also control our usage sources. What’s the betting that when your ISP starts offering movie downloads, those won’t count against your monthly usage cap? Or, at least, not as heavily as downloads from other sources. (They’ll tout this as “a special feature for our valued customers.”)

    Personally, I’m not at all convinced the ISPs actually need this new revenue. For example, if they’re trying to optimize usage, why not offer variable billing by time of day? Surely someone downloading at 4:00am isn’t costing them the same as someone streaming in prime time? No, the logic of this new scheme points in a very different direction. A very dangerous direction for the future of an open Internet.

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