At the Consumer Electronic Show two weeks ago, Netflix announced that it would block consumer access to high definition and 3D movies (HD) for customers of Internet service providers (ISPs) that Netflix disfavors. Netflix’s goal is to coerce ISPs into paying for a free Internet fast lane for Netflix content. If Netflix succeeds, it would harm Internet consumers and competition among video streaming providers. It would also fundamentally alter the economics and openness of the Internet, “where consumers make their own choices about what applications and services to use and are free to decide what content they want to access, create, or share with others.”
Ironically, Netflix’s strategy is a variant of the doomsday narrative spun by net neutrality activists over the last decade. Their narrative assumes ISPs will use their gatekeeper control to block their customers from accessing Internet content distributed by competitors. Of course, ISPs have never blocked consumer access to competitive Internet content. Now that the FCC has distorted the Internet marketplace through the adoption of asymmetric net neutrality rules, Netflix, the dominant streaming video provider, has decided to block consumer access to its content.
This may not seem like a big deal given the relatively limited HD content currently available on Netflix. But that’s about to change in a very big way. Netflix recently announced a new multi-year licensing agreement that makes it the “exclusive American subscription TV service for first run live-action and animated features from the Walt Disney Studios.” In addition to Disney-branded content (e.g., The Lion King), the deal includes content produced by Pixar (e.g., Brave), Lucasfilm (e.g., Star Wars), and Marvel (e.g., The Avengers). Netflix also announced a multi-year deal with Turner Broadcasting and Warner Bros. that includes the Cartoon Network and exclusive distribution rights to TNT’s television series Dallas. As an analyst recently told Ars Technica, “These movies, if you’ve got young kids—you’ve got to have Netflix.”
Netflix has decided to use this new market power to force ISPs to pay for its own Internet fast lane. In classic double-speak, Netflix calls its fast lane the “Netflix Open Connect” content delivery network (CDN). Though Netflix uses the word “open” to describe its CDN, it is not part of the open Internet. It is only “open” to Netflix for the delivery of its content, and it is only “open” to ISPs who connect to it on terms dictated by Netflix.
The costs of the ordinary CDNs (e.g., Level 3 and Limelight) that deliver Netflix are borne by Netflix and incorporated into the price of its retail service. Netflix pays these CDNs to deliver content to Netflix subscribers, and the CDNs pay the costs of delivering Netflix content on the Internet. With this model, the additional costs of delivering Netflix content (due to its desire for distributed content servers) are ultimately borne only by Netflix subscribers.
With its “Open Connect” model, Netflix is withholding content from the customers of ISPs that decline to accede to its demands. Though the details of its demands are unknown, it appears Netflix is requiring that ISPs “peer” with them or pay for the installation of Netflix equipment inside their networks as well as the ongoing costs of operating that equipment.
Netflix’s model is inconsistent with standard Internet peering arrangements, harmful to consumers, and blatantly anticompetitive. By shifting its costs to ISPs, Netflix is distributing the costs of delivering its service across all Internet consumers. ISPs that agree to pay the installation and ongoing operational costs of hosting Netflix equipment inside their networks would have every incentive to pass these costs on to their subscribers as higher rates for Internet access. It would be one thing if ISPs were able to raise Internet access rates only for Netflix subscribers. Due to the FCC’s net neutrality rules, however, an ISP would likely be required to increase its rates for all of its subscribers to cover the additional costs imposed by Netflix – including its subscribers who don’t use the Netflix service. The result: ISP customers who subscribe to competitive streaming video providers would unwittingly be paying for the delivery of Netflix service as well, and Netflix would have a significant price advantage over its competitors.
Theoretically, streaming video competitors could mimic Netflix and try to force ISPs to cover the costs of private fast lanes for them as well. In reality, the combination of exclusive content arrangements, first mover advantages, and asymmetric net neutrality regulation enjoyed by Netflix make it unlikely that a new competitor could mimic Netflix’s strategy. Netflix admits it is the “world’s leading Internet subscription service for enjoying TV shows and movies,” and that its traffic accounts for more than 30 percent of peak Internet traffic on U.S. networks. According to Dan Rayburn at Streaming Media:
There are maybe half-a-dozen content owners who are delivering enough volume of bits, have the technical expertise and have the money to build out their own CDN. Only companies the size of Google, Apple, Microsoft, Netflix and Facebook can take on such a task.
He also notes that the average family of four likely has ten Netflix enabled devices in their home today – something that “can be done by others, but it takes time, a lot of money and lots of development.”
The available evidence indicates Netflix is shamelessly leveraging its market power and its subscribers to cajole ISPs into paying for its private fast lane at the ultimate expense of all Internet consumers and its competitors. When I inquired about its “Super HD” service on the Netflix website, the website replied in ominous red text: “Your Internet Provider is not configured for Super HD yet.” (Screenshot availablehere.) In a subdued, friendly gray, it said:
Super HD requires that your Internet Provider is part of the Netflix Open Connect network. Please contact your Internet Provider to request that they join the Netflix Open Connect network so you can get Super HD.
Neither my ISP nor the open Internet is preventing Netflix from allowing me to access its HD content. Netflix is choosing to block me from accessing its HD content because my ISP hasn’t agreed to host Netflix equipment for free and Netflix doesn’t want to pay another CDN to deliver HD content to my ISP.
Unfortunately, most consumers won’t realize that Netflix is trying to impose its costs on all Internet consumers to gain an anticompetitive price advantage against its over-the-top competitors. If most consumers end up blaming ISPs for Netflix’s choice, I expect Netflix will increase its demands along with its leverage as it secures exclusive access to even more “must have” content. I wouldn’t be surprised if Netflix attempts to graft the “basic tier” model used in traditional video subscription services on to the Internet.
Think Netflix doesn’t have enough muscle to bully ISPs? Think again. Although Netflix won’t disclose the full list of ISPs that have succumbed to its pressure tactics, Cablevision and Google Fiber in the U.S. and a host of global ISPs (including Virgin Media, British Telecom, Telmex, Telus, TDC, and GVT) have already agreed to install a “free” Netflix fast lane in their networks. The revenue and global scale provided by these deals combined with the asymmetric limitations of the net neutrality rules will make it even harder for the remaining ISPs in the U.S. to resist Netflix’s demands.
When the FCC considered adopting net neutrality rules, Commissioner Michael Copps warned of the potential for unintended consequences that attend asymmetric regulation: “In particular, we need to recognize that the gatekeepers of today may not be the gatekeepers of tomorrow.” Copps believed his “job [was] not so much to mediate among giants as it [was] to protect consumers.” Now that it is the Internet gatekeeper of Star Wars and other iconic films, what rule will stop Netflix from demanding additional payments from ISPs if net neutrality rules prevent ISPs from recovering the additional costs only from Netflix subscribers?