It works like this: customers sign up for separate phone and airtime plans at the same time, with the duration of the plans being 24 months. If the customer wants to upgrade their phone within that period, they can simply pay off the remainder of the phone plan, with no further penalty. O2 will then unlock their phone, unless the device is exclusive to O2′s network.

Similarly, if customers hit the end of the two years and don’t want a new handset, they only have to pay the monthly airtime fee from that point on. This is a lot fairer to the user than the traditional system, where the benefit to the operator of not having to provide an expensive new device after two years isn’t necessarily passed on to the customer in full.

Bye-bye “free”

By adopting this sort of interest-free financing scheme, O2 is effectively moving away from the traditional, opaque model of subsidising the handset up-front, then burying the true cost of the device in monthly contract payments. That’s not to say customers will pay more under the Refresh scheme — it just means they will more accurately see what they’re paying for, and will no longer be under the illusion that the handset they’re buying is “free”.

In the words of an O2 spokesman today:

“This isn’t about subsidies. Our main reason for doing this is to give people more freedom to get the latest phone whenever they want without paying any extra charges — our customers are telling us they don’t want to be tied to their current phone for up to two years.

“By allowing customers to pay for their phone and tariff in this way, we are also able to more responsibly manage our costs, which will mean a better service for our customers and greater investment in future products and services.”

That is indeed a problem carriers have these days with the subsidized model: people are increasingly adopting smartphones, which are complex and therefore quite expensive. By encouraging people to upgrade more often, O2 is making it likely that customers will pay it back for their phones more quickly than previously. It is surely no coincidence that the Refresh focus is on high-end devices such as the iPhone 5 and Samsung Galaxy S4.

The move also handily pre-empts Ofcom’s probable introduction of new rules for carriers around price hikes and letting customers leave early. The telecoms regulator is annoyed with the operators for raising their prices, then penalizing people who subsequently want to end their contracts before the term is up.

The Refresh airtime plans start at £12 ($18.43) a month, which will get you 600 minutes of call time, unlimited texts and 750MB of data. The phone plan pricing depends on the phone, obviously, but O2 said by way of example that the HTC One would cost £49.99 up-front, then £20 a month. The carrier said customers would end up paying the same amount as they would on a combined tariff.

So how will this pan out for O2 and its customers? For that, we can turn to an admirably frank post on O2′s The Lab blog from last month, written in response to T-Mobile USA’s similar move, and bearing in mind the experience of O2 parent Telefonica in Spain, where subscriber numbers subsequently increased:

“Could it work in the UK? Would customers be willing to pay up-front for their handsets? Would customers rather take out a loan from their mobile network and pay for the handset separately? Would customers compare prices across networks and simply choose the one which is cheapest today rather than looking at the [total cost of ownership]?

“I think moving to removing subsidies is great for consumers. It lowers the price they pay and means that they’re not beholden to an evil operator gouging them for two years. And, if at any point the customer wants the latest phone – they don’t have to go through a complicated upgrade procedure – just slap down the cash.

“For the operator, I think it’s also good news. It forces them to concentrate on customer service. They don’t need to extend large loans to the customer, nor do they need to compete on up-front cost. The downside, of course, is that the monthly revenue generated by the customer could be lower.”

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Speaking to reporters at a Verizon event in New York City, McAdam said the carrier would watch T-Mobile’s new no-contract strategy closely to see how consumers respond. “I’m happy when I see something different tried,” CNET quoted McAdam as saying. “We can react quickly to consumers’ shifting needs.”

Lowell McAdam (right) with Google’s Eric Schmidt

To be honest, you wouldn’t expect McAdam to say anything different. In the past, carriers have expressed dissatisfaction with the subsidy model that dominates the U.S. mobile industry. That model dictates they sell increasingly expensive smartphones at cut-rate prices and thus take a big financial hit when they first sign up a new customer. Eventually they recoup those costs over the course of a two-year contract through higher service fees.

Most carriers have already eliminated subsidies entirely for tablets, and as McAdam points out, they would more than willing to do so for phones, if customers are amendable. That said, Verizon has done quite well for itself with the current system — it has no reason to gunk up the works unless there is some massive shift in consumer sentiment.

There’s a reason why T-Mobile was the carrier to challenge the long-established contract-and-subsidy model: it had nothing to lose. It is the smallest — by a big margin — of the four national operators, and for the last several years it has barely grown. You can call its Un-carrier strategy an act of genius or you can call it an act of desperation, but T-Mobile had to do something and had to do that something quick. McAdam only has to sit back and wait to see if it works. And he’ll likely have to wait a while since many of the customers who might be interested in what T-Mo is selling are still locked into contracts.

So what if T-Mo’s new contract-free plans prove wildly successful? Would other carriers give up on contracts completely? I seriously doubt it. Verizon, AT&T and Sprint may have their issues with the subsidy model, but they also love to the stability of long-term contracts. The last thing they want is a constantly shifting customer base, in which huge numbers of subscribers turn over each quarter. Even if the carriers didn’t have to absorb device subsidies, there are still substantial costs associated with acquiring new customers. They would much rather just lock down the ones they have.

All three carriers offer prepaid services for customers who demand or don’t qualify for postpaid services, and most carriers will sell you a postpaid plan without a contract if you pay for your device upfront. In fact, they benefit considerably if you do so because they’ll charge you the same monthly rates they do for subsidized customers – they get their cake and eat it too.

That’s where I think the other carriers will have the biggest difficulty adjusting to contract-free models. To make that model the work they’ll have to charge lower voice, SMS and data rates to those customers who eschew subsidies. If carriers are no longer recouping the cost of the device, they can’t justify the rates they charge today. Lowering rates is not something they want to do.

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I don’t know for certain what will emerge at the event tomorrow, but I expect we’ll hear at least one, if not all, of the following three revelations:

T-Mobile finally gets the iPhone

The build-up to this single handset announcement has been endless, but tomorrow may well be the day that T-Mobile officially becomes an iPhone retailer. T-Mobile has confirmed the iPhone is coming. It just hadn’t set a date.

According to CNET’s sources, the iPhone will play a prominent role at tomorrow’s event. That’s sweet, but T-Mobile really needs to give specifics on availability and pricing tomorrow or it really shouldn’t even bother mentioning the iconic Apple device. Practically every discussion about T-Mobile USA for the last two years has revolved around when or if it would get the iPhone. As T-Mo has made abundantly clear, it’s getting the iPhone. The only thing we want to know is when we can buy it.

LTE goes live

This one is almost a given. T-Mobile has promised we’ll see a live LTE network this month, and there are only a few more days left in March. We’ve already seen a big spike in LTE testing activity in eight major cities across the country, and TMoNews has obtained internal documents indicating T-Mobile will launch in seven markets this week.

Either way, the carrier is well ahead of schedule. After its planned merger with AT&T flopped, T-Mobile launched an ambitious spectrum-refarming project designed to give it an LTE network in the second half of 2013. The impending launch of the iPhone, however, gives its LTE rollout new urgency since it wants to support the iPhone 5’s full radio capabilities as soon as it goes on sale.

Death to all device subsidies

New CEO John Legere has promised T-Mobile will remake the mobile industry by ending its long practice of heavily discounting devices in exchange for long-term pricey service contracts.

T-Mobile USA CEO John Legere

We’ve already seen the basic framework of that strategy emerge over the last year in T-Mobile’s Value plans, which still require contracts but offer much lower voice and data rates. Over the weekend, T-Mobile revamped its Value plans once again, making unlimited voice and SMS standard on all pricing tiers.

What we’re still waiting to hear about are the specifics of T-Mobile’s big strategy – to see whether it can truly separate service from the handset. Many operators have complained about the subsidy system in the past, but so far T-Mobile is the only major U.S. carrier to do anything about it.

What I’m waiting to see is whether T-Mobile truly follows through on its commitment to eliminating subsidies completely or if it just maintains its current policy of offering unsubsidized plans as an option. If it’s the former, T-Mo would take a huge risk, but it could change the U.S. mobile industry for the better.

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All of that legislation and bluster, however, isn’t going to solve the fundamental problem that produced the practice of locking devices in the first place: handset subsidies.

There’s a reason why carriers lock phones. They’re heavily discounting the cost of most devices, which is why you can get a $500 smartphone for $100 and many mid-range and low-end handsets for free. Carriers make their money back through monthly subscription fees that factor in those subsidy costs. For carriers to get the full value of the phone back, subscribers need to finish out their contracts, and locking devices to their networks functions as their insurance policy. It’s a hell of lot easier than repossessing phones.

The bottom line is most consumers don’t really own their phones. They’re mortgaging them. Just like you can’t sell your home without paying off your bank loan, carriers don’t want you selling your phone or taking it to another carrier without finishing your contract and paying off your handset loan.

Thus, we’re left with the locking mess, which leads to all of the problems pointed out by locking’s critics: Having to jump through hoops to get your carrier to unlock a phone when your contract is up, the inability to use another carrier’s SIM card when traveling overseas, and the difficulty of building a resale market for phones when the majority of devices are locked.

Why unlocking phones doesn’t solve the problem

Making it legal and easy to unlock phones might seem like an easy solution to this problem, but I guarantee you carriers will find some other way to protect their investments. Carriers could require deposits, implement some kind of collateral fee, institute more onerous contract restrictions, or they could simply raise prices. If carriers start losing money when customers skip out on the contracts, you can bet the customers that remain will have to make up the difference.

I’m not saying it’s right. I’m just saying that in this messed-up subsidy system, everyone is trying to protect their own interests. Consumers will try to unlock their phones, and carriers will try to stop them.

If we get rid of subsidies completely, though, all of those conflicting interests go away. Once you separate the service from the device, carriers have no interest — and no right — to lock devices. You may still be under contract, but since there is no subsidy recovery fee bound up in your monthly bill, carriers could care less what you do with your device.

Of course, paying full price for your phone is an expensive proposition. An unsubsidized iPhone 5 costs between $649 and $849, as opposed to the $200 to $400 most carriers charge with contract. But in the long run buying your phone up front will probably save you money. T-Mobile has been a trailblazer in this area, charging cheaper monthly rates for voice and data if you don’t opt for a phone subsidy. What’s more, once subsidies are gone, handset makers will be able to sell their wares directly to consumers, which could lead to a greater variety of devices and more price competition in the device market.

Ultimately, mobile voice and data rates are so high because our phones are so cheap — artificially cheap. If we reverse that equation, we wind up with cheaper subscriptions, more choice and phones we can do with as we please.

What can you do with an unlocked phone?

Unfortunately, having an unlocked device doesn’t leave you with too many options in the U.S. If you travel internationally with a GSM-capable phone you can plug in a local carrier’s SIM card and pay local rates. But in the U.S. itself there isn’t much mobility between carriers.

U.S. operators are split between GSM and CDMA camps, and while it is possible to activate a Verizon phone on Sprint’s network or bring an AT&T device to T-Mobile, there’s no guarantee that you’ll have to access every network or service they offer. U.S. carriers don’t just use different radio technologies, they use different spectrum bands. The band fragmentation problem got even worse with the introduction of LTE.

But there are signs that things will get better. T-Mobile is in the process of overhauling its network, aligning its 3G bands with those of AT&T. In 4G, we’re starting to see some LTE network convergence around the Advanced Wireless Services (AWS) band. We’re even seeing more dual-mode GSM-CDMA devices making their way into the market.

With emerging smart antenna and radio module technologies, handset makers will soon be able to pack a dozen bands into a single device. Eventually we might even see a universal phone in the U.S. that can work on any carrier’s networks, no matter what combination of technologies and frequencies they use. And if that point we’re no longer weighed down by subsidies, contracts or locked devices, consumers will be able to switch to any operator at their whim. That’s not a bad choice to have.

Mortgage image courtesy of Shutterstock user Stuart Miles; Smartphones image courtesy of Shutterstock user Reno Martin; SIM cards image courtesy of Flickr user mroach

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Though Legere and T-Mobile haven’t said explicitly which Apple device or devices the carrier would sell, the timing would put T-Mobile in line to retail the current-generation iPhone 5 a good four to five months before the smartphone is likely to be refreshed this fall. There’s also the off chance that T-Mobile might be a candidate for the rumored “cheap iPhone” Apple is supposedly developing.

Neville Ray, CTO, T-Mobile (c) 2012 Pinar Ozger pinar@pinarozger.com

What’s more, T-Mobile probably wouldn’t have to sell the iPhone as a mere 3G device as many international operators and smaller U.S. carriers are forced to do. T-Mobile CTO Neville Ray revealed at T-Mo’s big CES event that he would have a good portion of his LTE network online by mid-2013. Couple that with Ray’s rapidly accelerating HSPA+ network upgrade around the country, and T-Mobile will be able to support all of the iPhone 5’s connectivity capabilities in many of its markets at launch. Not bad for a carrier that couldn’t get anything more than a 2G signal to the iPhone just six months ago.

T-Mobile originally planned to launch LTE in the second half of this year, making it the last U.S. operator to deploy the latest generation mobile broadband technology. T-Mobile is still behind its primary competitors, but management has apparent lit a fire under Ray’s engineering team. At CES, Ray said T-Mo’s first LTE systems would go online in Las Vegas in the next few weeks, which would put him five months ahead of schedule.

The iPhone won’t be the only device benefiting from T-Mobile’s accelerated LTE plans. The Verge is reporting that T-Mobile will soon offer an LTE version of the Samsung’s popular Galaxy S III smartphone. Though The Verge didn’t name a launch date, the device could hit shelves well in advance of the actual LTE launch since T-Mobile could activate its LTE radios at any time with a simple over-the-air software update.

T-Mobile had a big CES. In addition to the LTE and iPhone revelations, T-Mobile made multiple updates to its technology and service plans.

• My colleague Kevin Tofel wrote about T-Mobile’s plans to take unlimited smartphone plans contract-free, answering one of T-Mobile customers’ biggest gripes. T-Mobile is moving to an unsubsidized model, meaning customers will either pay full freight for their devices, bring their own phones or buy them in installments. Since contracts are supposed to cover carriers’ upfront subsidy costs, enforcing contracts with no subsidy makes little sense. It will be interesting to see if T-Mobile moves away from contracts completely as it phases out subsidies this year.
• T-Mobile revealed its network is now high-definition-voice compatible, which means it can support a much higher call quality than current cellular voice systems. Three current devices – the Galaxy S III, the HTC One S and the Nokia Astound phone – will support the HD features, but there are also some big limitations to its initial appeal. As PC Mag’s Sascha Segan explains, HD calls will only work between T-Mobile devices that both have the HD client, and so far T-Mo’s technology is incompatible with any of the HD codecs other carriers are working on.
• In order to encourage devices other than smartphones onto is network, T-Mobile is offering 200 MB of free data each month for two years on select Windows 8 laptops. Called 4G Connect, the program could get really interesting if T-Mobile expands it tablets, providing a big incentive for consumers to buy 4G versions of the iPad and other slates.
• T-Mobile has upgraded its HSPA+ network to support iPhone frequencies in four more markets: Denver, Los Angeles, San Diego and Virginia Beach, Va. The network refarming is now complete in 46 cities covering 126 million people. The reconfiguration is key to T-Mobile supporting the iPhone’s data capabilities, and at its current pace should be largely complete at the iPhone’s launch.

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Ofcom’s move follows a great deal of pressure directly from consumers and from the consumer advice service Which?, which has run a campaign called Fixed Means Fixed since last July. On Thursday the regulator launched a consultation (PDF warning) on how to better protect people from price rises that are allowed under the small-print terms of their contracts, but that may not be obvious to most people when they sign up.

Why consumer protection could kill subsidies

Ofcom has proposed several options, which also include greater transparency of price terms and making it so that consumers must expressly opt into any variable-price contract. However, the regulator was clear that it favors changing the current rules so that “consumers are able to withdraw from a contract without penalty for any increase in the price for services applicable at the time the contract is entered into by the consumer.”

What does this have to do with handset subsidies? Everything.

Here’s how the current system works. Operators can raise their prices without letting customers bail out for free, as long as the hike falls short of causing ‘material detriment’ to the customer. What’s material detriment? Good question. It’s pretty much up to the operator to decide, and their measurements are wildly inconsistent – some set the barrier at inflation, some set it at 10 percent, and some mix those two up, depending on which ‘part’ of the overall charge we’re talking about.

You can hardly blame the average customer for not keeping up, and Ofcom says this situation is allowing a rather unhealthy trend. From the consultation document:

“With regards to the size and frequency of price rises in fixed term contracts, we consider there is a risk of these becoming a standard and regular practice in the communications sector. We note that some providers have increased prices more than once since 2011. Since most providers set a threshold… before they allow consumers to exit without penalty the incentive to raise prices once consumers have signed up to them will be large and any reputational damage to a provider will be diffused because competitors have pursued similar policies in the past.”

Which? itself recently pointed out that, in the last 15 months, all the major UK operators raised their prices at least once. The group’s campaign has garnered 37,000 signatures, and Ofcom has of course received many complaints about price hikes directly – it analyzed 1,644 of them in preparation for the new proposals.

Now, the operators have complained to Ofcom that “they are likely to review the way they currently subsidize handsets in order to reduce the risk to them if they have to let consumers exit the contract without penalty for any price rise”.

And what’s Ofcom’s response? A resounding “meh”:

“Our provisional view is that any disadvantages arising from changes in the way in that handsets are obtained by consumers would be outweighed by the protection offered by this option. This is on the basis in particular that handset manufacturers and handset/communications services retailers will continue to have a strong incentive to ensure that consumers are offered competitive and attractive deals for handsets.”

In other words, if Ofcom’s proposals go through, we may very well see a change in the way mobile phones are sold in the UK – currently a predominantly post-pay market, but maybe not for much longer.

In practice, this will probably mean that operators start charging a larger upfront fee for the handset in order to offset the risk of the customer quitting, or – as is already the case from where I sit here in Germany – splitting the contract in two, so that one part of the monthly charge is explicitly paying off the handset, and the other representing the service charge.

Either way, the actual cost of the handset would become much more apparent to the customer, making out-of-contract price a much more sensitive issue. Which is where the Nexus 4 comes in. Even less-savvy consumers can currently assess the low Google Play price and realise that they’re paying more than necessary if they get it on contract. This will only accelerate that trend, particularly if the Google-phone pushes down smartphone pricing in the same way the Nexus 7 did for tablets.

Let’s see if Ofcom’s proposals go through. The consultation closes on 14 March, after which Ofcom will reveal the finalized rule-tweaks. Operators will then have three months to change their strategies accordingly, so we could very well be looking at a major shift in the UK mobile market before the end of this year.

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Both MetroPCS and Leap Wireless’s Cricket Communications recently launched financing programs of their own to encourage their prepaid customers to buy high-end devices like the iPhone 5, FierceWireless is reporting. Metro and Leap executives both told Fierce that they are working with Progressive Financing – MetroPCS is additionally working with BillFloat – to offer low, up-front payments on otherwise expensive devices, making up the balance through monthly installments.

Cricket customers can walk out of the store with an iPhone 5 — which Leap normally sells partially subsidized for $500 — for $105. Customers will wind up paying more for the device via interest and repayment fees, Fierce reported, but neither BillFloat nor Progressive require a credit check, which fits well the carriers’ prepaid business model. Instead, the companies withdraw payments directly from a bank account.

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In an earlier note he wrote:

“Given our assumption of approximately $425 in carrier subsidies per handset, we believe the U.S. carrier market could be on the hook for more than $10 billion over the last three and a half months of the year alone, entirely due to the new iPhone launch.”

No wonder AT&T’s Ralph de la Vega wants to see subsidies drop.

King also noted that AT&T was trading at a price-to-earnings ratio unseen since the third quarter of 2005, before the iPhone even hit Ma Bell. Meanwhile Verizon’s shares are trading at a P/E ratio that has hit a 10-year high. Basically King is saying the stock has hit a fair price point and thinks the second half of the year may prove disappointing because of the high iPhone subsidies.

But it’s not all gloom and doom for the carriers. They get new contract customers in a saturated mobile market that will use a lot of data. Since the carriers are doing everything they can to move customers to the newer and more profitable shared data plans, the up front margin loss should work itself out over the life of those contracts.

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Iliad founder Xavier Neil told France’s Capital magazine that those fees wind up amounting to interest rates of 300 to 400 percent in a one-to two-year contract. That may sound excessive, but if you take a closer look at huge gap in pricing between prepaid and postpaid carriers, it doesn’t seem too far off base.

Free Mobile, for instance, doesn’t offer a subsidy on its devices and it manages to sell voice and data at ridiculously low rates, which is what set off the France’s price war in the first place. Of course, Free uses a few technical tricks to keep its prices low, the biggest being the 4 million home and business Wi-Fi access points it uses to offload data traffic.

But shunting traffic off of expensive cellular networks doesn’t explain the price differences entirely. You only have to look to the U.S. prepaid and mobile virtual network operator (MVNO) sectors to see that. Prepaid operators like Leap Wireless’s Cricket and MetroPCS offer voice and data plan equivalents to AT&T and Verizon’s at very steep discounts. They require customers to pay all or most of the costs of their handsets up front. In exchange, they not only charge cheaper rates but don’t tie customers down to contracts.

The price gap is even more visible when you start looking at the new batch of MVNOs emerging in the U.S. Operators like TracFone’s Straight Talk, H2O Wireless and Red Pocket just sell SIM cards, but they offer unlimited voice and SMS plans as well as data buckets that undercut major carriers’ prices by half or more. These operators have no ingrained technology advantage. They’re buying their minutes and bytes from AT&T and T-Mobile at wholesale rates, but they’re charging significantly less when it comes to retailing the final product.

In Europe, procuring your device and your service plan separately is common, but it’s still very much a foreign concept in the U.S. where consumers have become accustomed to the idea that smartphones are cheap disposable electronic goods. Carriers have been more than willing to reinforce that misconception so long as customers are willing to pay high monthly rates and sign long-term contracts.

There are signs of change, though. T-Mobile – which already offers some of the cheapest rates for a major carrier – is aggressively pushing its value plans, which offer significant discounts on voice and data plans if subscribers pay for their phones up front or bring their own devices to the party. It’s going to take more than just T-Mobile to change consumer mindset. Other carriers have signaled they’re open to the idea of unsubsidized plans, but the impetus for change may come from consumers, not carriers.

There’s a growing discontent with the high price of mobile service, and a sizable number of prepaid operators and MVNOs have arisen to feed that discontent. Eventually the realization will follow that the high prices we’re paying aren’t necessarily for data, rather we’re paying back the mortgage on our phones.

Featured photo courtesy of Shutterstock user Stuart Miles; SIM cards image courtesy of Flickr user mroach

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