Over the past 20 years, in line with the proliferation of the internet, net neutrality has been a hot topic of conversation within the telecoms sector. Of late, we have found the debate has resurfaced given the growing importance of the internet to our daily lives, coupled with the ever-increasing levels of investment required for network development to maintain pace with user demand.
What is network neutrality, and why is it important?
The term dates to 2003, first coined by Columbia University law professor Tim Wu, in a paper that examined broadband discrimination in relation to telecommunications policies and innovation. Today, this is often referred to as ‘net neutrality’ and is the principle that an internet service provider (ISP) must treat all internet communications equally, granting the same levels of access and speed across all sites regardless of the platform used or type of content being consumed. ISPs are therefore not permitted to charge users increased rates based on these differentiating factors.
The preservation of innovation is the crucial mission of net neutrality. The simplistic idea is that, in the absence of net neutrality, the largest and richest companies could pay telecom operators for the fastest speed and strongest connection to their websites and apps, effectively improving the user experience. This could degrade the user experience of rival sites who might not have the ability to pay for increased bandwidth, ultimately stifling their growth potential.
The preservation of innovation is the crucial mission of net neutrality
The internet is asymmetrical
When it comes to telcos, the questions at the forefront of investors’ minds have long been centred around the path to network monetisation. Over the last decade, we have seen an exponential growth in data demand, driven by the increased penetration of both mobile and fixed-line networks, greater access to personal computers and smartphones, and strong innovation in both content creation and delivery. In turn, global internet data traffic has increased by greater than 20% annually, with the five-year compounded annual growth rate (2016 – 2021) at 24% (see chart below).
Global IP data traffic (2016-2021)
Annual growth at +20%, leading to a 24% CAGR
Since 2020, the global pandemic has further accelerated the demand for connectivity. With the development of data-heavy applications such as Virtual Reality (VR), Augmented Reality (AR), Internet of Things (IoT), Smart Cities and Industry 4.0, it is widely expected that this accelerated pace of growth will continue. At present, internet usage is asymmetrical.
The data in the chart below shows that in the first half of 2021, total internet traffic was heavily dominated by video (streaming, embedded video advertising, video conferencing etc), comprising more than half of all internet usage. An even more shocking statistic is that Big Tech (Google, Facebook, Netflix, Apple, Amazon & Microsoft) were responsible for 57% of all internet traffic, meaning everything else online outside of these six companies accounted for less than 43%. This asymmetry presents telcos with additional complications regarding network monetisation due to the ‘web’ of internet participants, despite a one-directional flow of data traffic.
Total traffic by application
Video represents >50% of internet use
Total traffic by content producer
‘Big Tech’ dominates bandwidth requirements
The current asymmetrical environment in which the internet has evolved has material implications for telecommunication providers. According to the UK regulator Ofcom, the average UK household fixed-line data usage increased to 453GB per month in 2021, an increase of 5% over 2020, but +44% over 2019¹. On a global scale, estimated average household usage is between 650-750GB per month, with a continual increase in the number of ‘power users’ generating more than 1TB² of monthly data.
In the mature and highly competitive telecoms market, one where data demand is high among the customer base, operators have been using ‘unlimited’ data packages to attract subscribers. In most developed markets, telecom contracts are typically 24 months, meaning customers monthly costs are fixed for that two-year period, regardless of how much data they consume. The exponential growth in data requires an increasing level of network investment to ensure sufficient bandwidth to maintain network quality, an operating cost that outpaces potential price increases. This, coupled with fixed-price charges, raises further doubt over the sustainability of the current pricing model.
At present, the telecoms market is largely considered a ‘one-sided’ market, where ISPs derive most of their revenue from a single class of users (charging the end-customer a monthly fee for their internet connection). This pricing model dates back to a point where network traffic was dominated by symmetrical voice traffic but has failed to evolve in line with the present-day situation of unbalanced data flow.
In turn, it can be argued that the current telecom market has evolved into a ‘two-sided’ market, where an intermediary facilitates the interaction of two groups via a platform. Typically, in ‘two-sided’ markets, the platform provider generates revenue by charging both sides of the transaction, much in the same way that many online platforms take a sales percentage from both the buyer and seller (think Airbnb or Uber). With the exponential growth in the popularity of Over-The-Top (OTT) content providers, such as Netflix, AppleTV, Disney+, the telecoms market bears a striking resemblance to a ‘two-sided’ market, with operators facilitating two groups to interact via a platform: consumers and content providers over fixed and mobile networks.
A call for rebalance
Across the global telecom sector, operators are faced with the double upgrade requirements of rolling out 5G and fibre -a highly capital-intensive endeavour. As of 2021, total European telecoms investment reached EUR52.2bn annually, the highest level in six years³.Given the significant capital outlay, operators and investors alike are looking at how these investments can generate healthy returns.
Historical capital expenditure
FY12 combined capex spend 11% higher vs FY17
Despite the majority of internet bandwidth usage stemming from six major tech companies, the principle of net neutrality (see above) prohibits ISPs from charging customers increased rates to access these applications. In turn, ISPs are intensifying the ‘two-sided’ market debate, highlighting the possibility of OTT providers contributing to network investments.
In 2017, and again in 2021, a collection of CEOs representing some of Europe’s largest telcos, wrote an open letter to EU policymakers. These letters highlight the increasing level of network investments currently being undertaken to achieve the European digital leadership ambitions. At the same time, operators highlight the added environmental benefits stemming from energy-efficient technology. CEOs are calling for EU policymakers to better align their digital ambitions with improved competition policies, with one particular request calling for a ‘renewed effort to rebalance the relationship between global technology giants and the European digital ecosystem’.
Significant costs associated with OTT demand
In March of this year, Frontier Economics published a report (Estimating OTT traffic-related costs on European Telecommunications networks4) which highlighted the substantial costs associated with delivering OTT content over telecoms networks. The report was commissioned by Deutsche Telekom, Orange, Telefonica and Vodafone, for the purpose of supporting their policy improvement requests directly at the European regulators.
The findings highlight significant costs incurred by network operators to deliver traffic;
To recognise the costs associated with OTT content that vary with traffic, the report provides a breakdown of the incremental costs which vary with higher data loads.
A real-world example of this cost dynamic was demonstrated by South Korean ISP, SK Broadband, who sued Netflix in an attempt to reclaim costs associated with increased network traffic and maintenance work. These costs stemmed from a surge of viewers linked to the success of a particular South Korean show, as Netflix data traffic increased 24 times. The court ruled in favour of SK Broadband, ordering Netflix to pay for the surge in traffic, although Netflix are currently appealing.
Rebalancing the playing field
The European telecom sector is a mature and competitive environment, characterised by low growth, high capital expenditure requirements and elevated leverage. At present, CAPEX requirements are pressuring free cash flow (FCF) generation and, in turn, limiting companies’ ability to de-lever. As credit investors, we recognise the material value in well invested telecommunication networks (see: What is driving the sudden spate of telecoms buyouts and is it good for investors?) but also acknowledge the increasing level of cost associated with achieving such upgrades.
1 Ofcom – ‘Connected Nations 2021 UK Report’, (2021)
2 Sandvine – ‘The Global Internet Phenomena Report’, (January 2022)
3 Reuters – ‘Europe’s telcos want U.S. tech giants to help fund network costs’, (November 2021)
4 Frontier Economics – ‘Estimating OTT traffic-related costs on European Telecommunications networks’, (2022)