Imagine if one company out of the Fortune 500, #474 with ~$6b in revenues, and 2,000 employees, representing about .03% of U.S. GDP, and .06% of the population, comprised 36%of all the vehicle traffic going in one direction on our interstate highway system on any given day.
Now imagine that one company’s lobbying was instrumental in convincing the government to grant that company’s business model the right to commercially use the highway system forever for free, by not ever having to pay a standard gas tax or private highway tolls, like other businesses or people do to pay for the relative wear and tear that their usage causes on the highway systems.
Imagine further that the government justified this special one-way highway traffic treatment, by saying it would be better and fairer for everyone if the companies that use and profit most from using the most one direction of the highway system never had to pay for that delivery benefit – that consumers should subsidize their commercial use and profits in “perpetuity.”
The company’s situation you just imagined is Netflix’. The government agency is the FCC. And the perverse government arrangement is the FCC’s mandate of a permanent zero price for all Internet downstream traffic.
Investors love Netflix, and appear blissfully ignorant of the unique and extreme regulatory arbitrage on which Netflix’ business and growth model rests, and the considerable regulatory risk Netflix faces over the next couple of years, domestically and internationally.
By way of background, it is important to remember Netflix started and thrived as a DVD mail rental service where its postage bill to the U.S. Postal Service was its biggest expense. Netflix brilliantly pivoted from mailing DVDs to Internet streaming earlier and better than most anyone.
The underappreciated brilliant part of that pivot was how Netflix and others were able to ensure that its distribution costs to consumers would go from its biggest expense to being completely subsidized by the government by getting the FCC to set a de facto permanent price of zero for all Internet downstream traffic under the guise of net neutrality.
A hinge-point in the operative concept of net neutrality was a 2009 paper by Professor Tim Wu entitled: “Subsidizing Creativity through Network Design: Zero-Pricing and Net Neutrality.” Netflix and others seized on this commercial-subsidy version of net neutrality and got that new subsidy notion embedded in the FCC’s first Open Internet Order in 2010.
From 2010 to 2014, Netflix’ burgeoning streaming business was heavily subsidized by the FCC’s de facto price regulation of a permanent zero price for downstream Internet traffic.
In 2014, the Appeals court decision, Verizon v. FCC, threatened Netflix’ gravy train because the court struck down the Wu-Netflix-subsidy-notion of net neutrality by concluding the FCC did not have the legal authority to compel an ISP to furnish service at no cost.
Netflix then played a leading role in getting the FCC majority to oppose “Internet fast lanes” — i.e. the FCC’s ban of “paid prioritization” — which sets a de facto permanent price of zero for all downstream Internet traffic under the FCC’s assertion of Title II authority, which by the way has been challenged yet again by the entire broadband industry.
For now… Netflix has mastered regulatory arbitrage under the banner of net neutrality.
However, going forward, prospects for the FCC net neutrality, subsidy-gravy-train continuing uninterrupted appear to be more uncertain than Netflix supporters and investors appreciate.
Long term, Netflix is at least partly an FCC-dependent investment.
Domestically, the fate of Netflix’ zero-price distribution subsidy depends on the fate of the FCC’s Open Internet Order, which faces a highly uncertain outlook in the next couple of years.
As I recently explained in my analysis: “The FCC’s Title II Trifecta Gamble,” the FCC’s Order faces cumulative risk that the Title II authority it asserted in the Order will not withstand the following gauntlet of serious risks: first a House appropriations provision to defund Title II implementation; second a united-industry court challenge to overturn the legality of the Order; and third a Republican in the White House in 2017 whose FCC Republican majority would reverse the existing order.
To appreciate the cumulative risk here, to the Order and to Netflix’ regulatory gravy train, assume each outcome faces a 50-50 risk. An odds maker would tell you that .5 x .5 x .5 = .125 (12.5%) or 8-1 odds against the FCC and Netflix winning this effective trifecta gamble over the next couple of years.
Internationally, the President’s call for the FCC to reclassify the Internet as a Title IItelecommunications service creates substantial business model risk for Netflix in particular.
Under International Telecommunications Union (ITU) treaty, if a country that Netflix is targeting for growth, decides to follow America’s lead and classify the Internet into its country as “telecommunications,” it legally could impose a treaty-sanctioned sending-party-pays economic model and charge Netflix for its terminating traffic into their country.
In short, the market appears to view Netflix as a momentum play that faces little risk to its current momentum.
Such sentiment appears to ignore the risks to Netflix’ hidden subsidized economic model from Congress; the courts; the 2016 election; and other countries reclassifying downstream Internet traffic into their countries as paid telecommunications termination.
[Originally published at Precursor Blog]
Scott Cleland is Executive Director of the Restore Us Institute, an internet policy think tank and nonpartisan, faith-based nonprofit with a mission to restore internet accountability to protect people from online harm.
