Will the Demise of Net Neutrality Lead to Naked Exploitation?

The D.C. Circuit's decision to strike down "net neutrality" rules has led to a firestorm of criticism in the past week. Open Internet advocates have painted a picture of a doomsday scenario where Internet service providers such as AT&T (T 0.19%), Verizon (VZ 0.03%), and Comcast (CMCSA -0.33%) could eventually place severe restrictions on the content their subscribers can receive.

Open Internet advocates are worried that ISPs like Comcast could play favorites.

In this scenario, big companies such as Google (GOOGL 0.69%) and Netflix (NFLX -0.62%) will have to pay big bucks to ISPs to get access to consumers. However, start-ups with limited resources would be in even worse shape; they could be confined to "slow lanes" that could make it impossible to compete with the established players.

This sort of naked exploitation -- where ISPs make big Internet companies pay up to get the same service they have today -- is hard to fathom. Consumers would revolt if their favorite websites were suddenly "throttled." However, there may be other, more clever ways for ISPs to profit from a looser regulatory climate, particularly through usage-based pricing and "sponsored data."

Usage-based pricing
Usage-based pricing could provide a backdoor for ISPs to develop a secondary revenue stream from major Internet companies. Put simply, usage-based pricing could either involve a simple data cap or a set of tiers where customers could choose how much monthly data they want to buy. These policies have been common for smartphone data plans for several years, but they are relatively new for U.S. broadband users.

However, usage-based pricing is becoming increasingly common for ISPs. Comcast has been testing monthly data caps starting around 300 GB. AT&T has been testing data caps at 150 GB and 250 GB, depending on your service tier.

Right now, this is not a problem for many people. ISPs have claimed that less than 1% of users are at risk of exceeding their normal data caps -- and for those customers, they offer more expensive, higher-speed/higher-cap plans. Indeed, the average customer uses just 16 GB of data per month -- although that's up from just 9.7 GB a month in 2009.

The game-changer
However, streaming video -- and especially high-resolution streaming video -- is a potential game-changer. Netflix claims that HD video viewing uses about 2.8 GB per hour. The average Netflix subscriber uses it for 87 minutes per day, and watching that much content in HD would lead to more than 120 GB in monthly data usage from Netflix alone.

That's not all. Earlier this month, Netflix had a big presence at the Consumer Electronics Show, where it was talking up the virtues of 4K TV (also known as Ultra HD), a format with four times as many pixels as what is currently considered "full HD." Reed Hastings made guest appearances at LG and Sony press events to promote 4K streaming, which will be available "out of the box" through the Netflix app on their smart TVs.

Netflix is encouraging its users to consume much more data with 4K streaming video.

Indeed, Netflix executives have insisted that streaming will be the best way to get 4K content for the foreseeable future. Netflix is having all of its new originals filmed for 4K streaming, and it will also have a 4K stream of the popular drama Breaking Bad. Google has been promoting 4K heavily, too, and claims that its new compression technology will significantly reduce the bandwidth it needs.

Nevertheless, if 4K TV takes off in the next few years and streaming video continues to gain momentum, data usage could skyrocket. Netflix's 4K streams consume 15.6 Mbps of data, or roughly 7.2 GB an hour. Considering that the average American watches more than 34 hours of TV each week, a wholesale move to 4K streaming would create a data nightmare -- 34 hours a week at 7.2 GB an hour works out to around 1,000 GB on a monthly basis.

Sponsored data
If Netflix successfully convinces consumers that they should want to get most of their content from Netflix and that they should view it in 4K, more and more people will start to hit their data caps. Obviously, ISPs could just let that happen and start collecting overage charges. However, doing so would risk customers' wrath.

The demise of net neutrality gives ISPs another option: sponsored data. In this scheme, content providers such as Netflix (or Google's YouTube) could pay the ISPs a fee to be exempt from data limits. This would allow a company like Netflix to promote user engagement without driving people over their data caps.

Lest you think this is a "pie-in-the-sky" idea, it just so happens that earlier this month, AT&T rolled out sponsored data for its wireless plans. Given the low monthly data allotments for mobile devices, lots of companies could be interested in paying to exempt their sites and apps from data caps. For home broadband, streaming video is the only thing that uses enough data to make "sponsored data" worthwhile.

Danger or opportunity
Netflix is on a risky path, but one that could also represent a long-term opportunity. By encouraging subscribers to use Netflix more often and to do more of their viewing in HD -- and now 4K -- Netflix could singlehandedly drive huge jumps in bandwidth usage. YouTube is not quite as data-hungry, but it is also contributing to rapid growth in broadband data usage.

With data caps becoming more common, these services may need "sponsored data" arrangements to encourage customers to take full advantage of their offerings. This obviously represents an additional cost of doing business. On the other hand, for Google, it might be worth the cost to get more people watching targeted ads on YouTube. For Netflix, it could provide a rationale to create a higher price tier with sponsored data for customers who want to watch lots of 4K content.

For ISPs, throttling Netflix and YouTube in the hope of bolstering their own pay-TV services could backfire by igniting a firestorm of anger among customers, regulators, and politicians. Sponsored data arrangements are much more appealing, as they would force Internet video competitors to bear the cost of sending so much data over the Internet while creating a new revenue stream for the ISPs. The move to this type of system will take time, but the rise of data-hungry Internet video makes it almost inevitable.