Does Net Neutrality Create Incentives, or Not?

Net neutrality impact on revenue

"Policy advocates have been arguing about network neutrality for years. Some even argue that Internet access providers have less incentive to invest unless strong network neutrality rules are in place. 


Some might find that an odd argument, given the universal opposition to strong forms of network neutrality on the part of entities that actually own and operate access networks. Though service providers who operate networks nearly universally claim that incentives for investment are higher when there is freedom to create new services that prioritize packets in ways that enhance end user experience, some argue the reverse is true. 


Professors H. Kenneth Cheng, University of Florida Warrington College of Business Administration; Subhajyoti Bandyopadhyay, University of Florida Warrington College of Business Administration and Hong Guo, University of Notre Dame, argue that ISPs gain from encouraging "scarcity," which creates incentives for users to buy prioritization services. 


"We find that if the principle of net neutrality is abolished, the broadband service provider stands to gain from the arrangement, as a result of extracting the preferential access fees from content providers," they argue. 

"When compared to the baseline case under net neutrality, social welfare in the short run increases if one content provider pays for preferential treatment, but remains unchanged if both content providers pay," the professors argue. 

"Finally, we find that the incentive to expand infrastructure capacity for the broadband service provider and its optimal capacity choice under net neutrality are higher than those under the no net neutrality regime except in some specific cases," the professors say.  Consumer welfare under net neutrality rules

"Under net neutrality, the broadband service provider always invests in broadband infrastructure at the socially optimal level, but either under- or over-invests in infrastructure capacity in the absence of net neutrality," they maintain. 

But analysts at Frost & Sullivan argue that net neutrality has the potential to significantly discourage infrastructure investment. This is because investments in infrastructure are highly sensitive to expected subscriber revenue. Anything that reduces the expectation of such revenue streams can either delay or curtail such investments.

Operators would likely reduce investment due to the increased business risk, they argue. 

An operator denied the opportunity to generate service revenue would be forced to adopt other methods for covering deployment costs, Frost analysts argue. These could include simply passing along the costs to the consumer, creating service bundles that limit consumer choice or passing the cost along to content providers.

"To the extent that consumers were unwilling or unable to incur such costs, net neutrality could, ironically, have the effect of actually reducing broadband penetration," the analysts argue. 

Net neutrality acts like a tax on the Internet. It imposes overheads on network operators, which, in turn, decrease network investments, providing less opportunity, not only for the operators, but also for those that use the operators' networks as well. Net neutrality reduces investment


Frank Gallaher, Stifel Nicolaus analyst, warned of just that outcome in 2009. At least some other policy advocates are too sanguine about the impact on investment if harsh new rules are enacted, he argued. 


Likewise, Matt Niehaus, Battery Ventures analyst, warned in 2009 that telecom investment capital has been declining over the past 10 quarters. The capital flight is caused in large part because of a perception that there is too much competition in telecoms, and therefore further investment is less likely to provide an adequate return on capital investment.

 "It's a perception in Wall Street, there's too much competition, and therefore it's difficult for entities to obtain a great return, " he says.

  "One of the things that worries me, is you can execute very well, and the problem is you may do all those things right, yet it's not clear you will be rewarded on the back end for it," Niehaus says.

But S. Derek Turner, Free Press research director, says carrier investment decisions are driven by a variety of factors, but regulation plays only a minor role.

"In general, firms’ investment decisions are driven primarily by six factors: expectations about demand; supply costs; competition; interest rates; corporate taxes; and general economic confidence -- making the overall decision to invest a complex process that is highly dependent on the specific facts of a given market," says Turner. "It is simply wrong to suggest that network neutrality, or any other regulation, will automatically deter investment."


Carriers worry about investment climate

A Whale of a Problem

The stage now is set for huge conflict between state public-sector workers and taxpayers, and the reason is pension obligations.

Because almost all states are required to balance their budgets, general fund monies must be used to pay pension obligations if the pension funds come up short. They certainly will do that. The funds are generally underfunded, and make assumptions about fund returns that simply are not credible.

Utah has calculated it will have to commit 10 percent of its general fund for 25 years just to pay for the effects of the 2008 stockmarket crash, for example.

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States use the expected return on the assets in their pension funds as a discount rate. This is often around eight percent, and reflects the performance of the past 20 to 30 years.

However, such returns will be hard to come by in future. Given current bond yields of two percent and a typical portfolio with 60 percent  in equities and 40 percent in bonds, a total return of eight requires a return of 12 percent on equities.

With American equities yielding just two percent to 2.5 percent, that in turn would require dividends to grow by nine percent to 10 percent a year.

That simply is not plausible. In a state such as Colorado, nearly 55 percent of all funds will have to be spent on pension obligations, effectively reducing the amount of money available to fund on-going operations by fully half....IF investment returns come in at an overall eight percent.

That isn't going to happen. Nor do these forecasts take into account financial "black swan" events that destroy huge amounts of equity.

Who would bet that between now and 2022  there will not have been at least one major financial event that wipes out huge chunks of pension plan equity?

These forecasts are not realistic. Colorado will wind up spending most of its general fund revenues to pay pensions, unless something quite dramatic happens, and quite soon. That is not a "political" issue. It is a simple mater of public finance getting severely out of whack. Something will have to be done, and it won't be pleasant.

Either we get an unpleasant fix, or we decide now that in 12 years there is no money to fund on-going state government services.