Law 4: “Disaggregation is a lost cause”
Over the 130 years or so of telecommunications history there have been various regulatory attempts to ‘disaggregate’ the telecommunications industry. Do you remember the division between LEC’s (Local Exchange Carriers) and IXC’s (inter-exchange carriers) in the United States? We had our own version in Australia done on an international basis – Telecom Australia and OTC. So, the latest infatuation of regulators for so-called ‘vertical separation’ is nothing new.
In its simplest terms, ‘vertical separation’ is the notion that you can split telcos into a ‘network co’ and a ‘retail co’. Supposedly this gives all retail service providers, whether they own the network infrastructure or not, equal access to the network. Now, to be provocative, that presupposes (a) access is unequal now, (b) that this stimulates competition and innovation and (c) it optimises infrastructure investment. My contention is that all 3 of the above premises are fallacious.
The real debate is not whether access seekers have equal access to the network infrastructure, but the price they pay for it. In the real world, where economics rules (as opposed to the academic wonderland regulators live in) this will be determined by whether each player gets a return commensurate with their level of investment. I have drawn a simple diagram (pictured - right ) to show that vertical separation effectively makes this impossible. The values below are indicative only, but they show the amount of investment required in each layer of the delivery chain for a telecommunications service (on the right hand side) and the commensurate return you get for your investment in each layer (the left hand ‘tower’).
What is obvious from this model is that most of the investment goes into the network, but most of the return comes from the applications that sit on the network. To give you an example, about 5 years ago we did a study of video on demand. We asked consumers whether they would like video delivered on demand across the network. The answer was very strongly in favour of such a service (providing the video was delivered to the TV as opposed to a computer). However, we also asked those consumers who wanted the service what premium they were prepared to pay relative to hiring a physical DVD from the video store, given that the network delivery would save them the time and cost of going to the video store. The answer was a resounding zero – in other words the customer saw all the value in the content and not in the means of delivery.
The point of this is that if all the return is going to the application provider, what incents anyone to invest in the network? It is only the combined revenue that justifies the combined investment. Strangely enough this has always been the case in telecommunications – do you remember the days when long distance cross subsidised access?
Does this mean that there will be no competition in the applications layer? Of course not! Competition will continue to flourish, just as it does today. However, just as today, many applications will operate on a separate business model using advertising or subscription to fund themselves. However, such application business models do not fund the network infrastructure – they ride on top of it. The network is the enabler without which the Googles and Facebooks of the world would not exist, but these applications can not come close to supporting the investment in network infrastructure required to make the whole system work. As a proof point, the global telecommunications industry is roughly 4 to 10 times bigger (depending on whose figures you look at) than the global advertising industry (across all media – TV, radio, print, etc). Separating the mainstream applications such as voice and video from the network would ensure underinvestment in the network. Note that while Google talked big about spectrum auctions in the US, when push came to shove they did not actually buy any or proceed with any network rollout. Also note, that one of the Economist’s 3 predictions for technology in 2008 (www.economist.com) is congestion in the Internet. That will only be overcome by investment in core infrastructure such as transmission and routers.
In summary, if you do not want to cause the demise of the goose that lays the golden eggs (eggs plural to include the plethora of applications such as Google, Youtube, Facebook, etc), namely the network, you need to create a business model which ensures that it receives adequate investment.